Updated: May 3, 2013 12:14PM
Originally published: February 21, 2005
There are three ways to lose money when you buy bonds. At least there were three dangers until last month. Now, one big problem has been solved, as you’ll see below.
Most investors have only a vague idea that it’s possible to lose money in bonds. After all, when you buy a bond, you’re lending money to the issuer: a company or a unit of government. You’re a creditor, first in line, before the shareholders, if the company gets in trouble. But in an era of volatile interest rates and heavy trading, bonds can be as potentially dangerous to your investment portfolio as stocks.
The first way you can lose money in bonds is by default. In these days of huge corporate bankruptcies, it’s possible that creditors get only pennies on the dollar for the money they loaned to the company. You can minimize that risk of default by sticking to highly rated bonds.
The second way you can lose money in bonds is through interest rate risk. When interest rates rise, bond prices fall. That risk applies to all bonds, whether issued by companies, local units of government or even the highest rated credit of the United States government.
Interest rate risk
Even if you buy high-quality bonds, the price will move up and down, inversely with interest rates. After all, if rates rise to 6 percent, no one will pay you $1,000 for your old 5 percent bond. That’s interest rate risk.
The longer the maturity of the bond, the greater the price risk when interest rates move. To avoid that risk, you must buy longer term bonds only when you think interest rates are at their peak.
Of course, that is easiest done in hindsight!
The third bond risk is the hardest to spot. It’s the risk that you’ll pay too much to the broker when you buy your bond, and get too little money when you sell. That pricing risk exists because -- up until now -- it’s been difficult to know the “correct” price of a bond, how it has traded in recent minutes, much less days.
That’s because, until now, there has been no computerized pricing service for bonds. That opaque market has allowed brokerage firms to mark up bond prices to bond investors, even if it doesn’t show as a commission. They simply buy the bonds for their own account, then sell them to customers at a higher price, making a profit for themselves at the expense of their customers.
Individual investors who buy smaller amounts of bonds -- less than $100,000 face value -- are most likely to pay higher prices for purchases or receive lower prices on sales. That’s why I typically suggest investors use no-load, low-cost bond funds, where professionals negotiate prices and get the best deals.
But as of this month, there are two new Web sites that post real-time pricing information for bond trades, within 15 minutes of a trade. Each allows you to search bonds by the name of the company or state that issued the bond, or by the security code (CUSIP) number on the bond.
You’ll see the most recent trade (within 15 minutes) and the number of bonds traded as well as the price. It’s as if suddenly there were a bond ticker tape. Even better, it’s a computerized and searchable Web site in real time.
The two Web sites are free and instantly available to investors:
*www.InvestinginBonds.com: This is the Web site of the Bond Market Association, which represents securities firms, banks and dealers. It covers pricing on corporate, municipal and government bonds.
*www.nasdbondinfo.com: This site was created by the National Association of Securities Dealers. It covers only corporate bond prices.
A realistic pricing service
Now you can check on the current value of bonds you own, and you can make sure that if you’re buying or selling, you’re getting a realistic price.
That’s one less reason to beware of bonds, though you must still understand credit risk and interest rate risk.
There’s no easy way to make money in the markets. But paying the correct price for bonds just got easier. And that’s The Savage Truth.
Terry Savage is a registered investment adviser, and appears weekly on WMAQ-Channel 5’s newscasts. Distributed by Creators Syndicate.