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Beware of Bonds

03/29/2015 09:55 am ET | Updated May 29, 2015

Bonds are just as risky as stocks. That's a simple fact not recognized by many investors, who still view bonds in their historic sense of being a more secure investment because they have a priority call against a company's assets in case of a bankruptcy. That's true -- in the long run.

But in the short-run bond prices can be just as volatile as stock prices -- costing you money if you must sell at the wrong time, or if you hold them and are stuck with below-market yields.

Here's a simple rule that applies to all bonds: When interest rates rise, bond prices fall.

That's just the way bonds work. If you own a low-yielding bond when interest rates go up, then market participants will offer you less than the full face value of your bond if you want to sell. The amount of this price discount depends on the "maturity" of the bond -- the length of time before the issuer promises to repay your $1,000 face value.

The longer the maturity, the greater the price decline when rates change. Short-term bonds, with maturities of three years or less, will be far less impacted by rising rates than bonds with longer maturities.

Here are some more things you should know about bonds:

1. Bonds have credit risk, as well as market risk. The price risk described above is called "market risk." But there is also a risk of default -- "credit risk." Bonds carry ratings that attempt to quantify that additional risk. Risky companies must offer higher interest rates to get borrowers to buy bonds. So higher coupons are likely a reflection of repayment credit risk.

2. All bonds share these risk characteristics. You can buy government bonds, corporate bonds, municipal bonds -- each with different protections and guarantees. For example, muni bond interest is tax-free, thereby boosting overall return to taxpayers in high brackets. Government bonds are usually perceived as less risky than corporate bonds -- though that is not always the case. But no matter what type of bond, when rates rise, prices will fall.

3. Bond prices are opaque. While prices of individual stocks are quoted instantly, prices of individual bonds are less visible, leaving small investors open to price discrepancies. To find current prices on most bonds, before buying or selling, go to the Bond Center at Finra.org.

4. Bond funds don't protect against market risk. There are two types of bond funds -- fixed portfolios and managed funds. A fixed portfolio of bonds means you are buying a package of bonds that will remain unchanged. Having a diverse bond portfolio may mitigate credit risk, but the value of the fund will fall when interest rates rise. Bond funds with managers may try to minimize price fluctuations, by holding cash, or choosing among bonds, but when rates rise, even these managed fund prices will inevitably fall.

5. Bond yields don't always reflect credit and market risk. Sometimes external forces can push bond yields down to very low levels -- despite market risk. Here's an example: United States 10-year Treasury bonds, widely considered the safest asset in the world, are currently yielding about 2 percent.

But at the same time, German 10-year bonds are yielding only 0.2 percent, and Japanese 10-year government bonds are yielding 0.35 percent! Even 10-year bonds of Spain and Italy are yielding only just above 1 percent. They're not safer -- but their lower yields result from the European Central Bank's bond-buying program to stimulate the Eurozone. Central bank bond-buying pushes yields down.

As you can see, bonds are no longer safe investments for "widows and orphans." Instead, they are impacted by domestic interest rate changes, global central bank actions, and the trading decisions of hedge funds and other sophisticated investors. You'll want to stay out of their way. And that's The Savage Truth.

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