Out of disaster often comes opportunity.
Such is the case with Treasury securities, municipal bonds, corporate bonds and other types of bonds. Before the recent stock market crash, many investment advisers were bearish about bonds, afraid that higher interest rates and rising inflation would erode their value.
But in the first few days after the stock market carnage, bonds arose with new-found luster. Large institutional investors, seeking a safer haven than stocks in a classic "flight to quality," poured billions of dollars into bonds, particularly short-term Treasury securities.
However, just like the stock market, the bond market is undergoing a period of high uncertainty and volatility. It is the result of a murky outlook on interest rates, the dollar and the U.S. trade and budget deficits. In the past few days, new worries about a falling dollar--which drives down the value of U.S. bonds to foreign investors--have prompted some experts to worry that both bonds and stocks could be in a prolonged bear market.
So is now a good time to buy bonds or bond mutual funds?
Yes, particularly if you want a steady source of income or if you are convinced that interest rates are headed down, advisers say. But just as in picking stocks, small investors should exercise extreme caution in choosing the right bonds and bond mutual funds. While some are quite safe and stable, others are risky and volatile, rising and falling in price nearly as much as stocks.
The prices of some types of bonds and bond funds are so volatile "that you could lose all your gains in a single day," said William E. Donoghue, editor of Donoghue's Moneyletter, a newsletter based in Holliston, Mass. Some bonds "are simply a speculative vehicle that people should not invest in for income, particularly in these uncertain, volatile markets."
Also, a recession--which many economists forecast for next year--could boost defaults on interest payments of some corporate bonds, particularly so-called high-yield "junk" bonds. A recession also could increase risks of default for some tax-exempt municipal bonds as well.
The following questions and answers could help you determine whether, and what type of, bonds are for you:
Q: What is a bond?
A: When you buy a bond, you are in effect lending your money to the bond's issuer--usually a corporation or government entity--in exchange for payments of interest. The bond obligates the issuer to make those payments, usually at specified intervals, and to repay the face value, or principal, of the bond at maturity.
Bonds are used by corporations and government entities to finance a wide variety of activities, ranging from factory construction to takeovers of other companies.
Bonds, however, do not entitle the investor to a say in the affairs of the issuer. Stocks, on the other hand, are a form of ownership of a company and give holders a right to vote on certain corporate matters. They also represent a claim on the company's earnings and assets, in many cases paying income to investors through dividends.
Investors can buy both stocks and bonds when they are newly issued. But investors who want to buy or sell already issued bonds can do so through brokers or, in the case of some bonds, through the issuer. To facilitate the buying and selling of already issued stocks and bonds, they are traded on exchanges and other types of markets, and their prices rise and fall according to economic conditions and investor demand.
Q: How do bonds compare with stocks?
A: Bonds traditionally have been thought of as steady, long-term investments that investors buy and hold to earn a stable rate of return. Stocks, on the other hand, have been considered more risky because of their volatility.
But that view is changing. First, studies show that over the past 60 years or so, stocks on average have outperformed bonds. One such study, by researchers Roger G. Ibbotson and Rex A. Sinquefield, shows that, since 1926, stocks have earned an average 9.3% rate of return versus only 3.6% for long-term government bonds and 3.3% for Treasury bills.
Second, the nature of bond investing for the small investor has changed radically. Years ago, most small investors in bonds bought individual issues, collecting interest and holding them until maturity.
But today, most small investors buy bonds through bond mutual funds. Funds are available that invest in nearly every type of bond with different maturities. For the same amount of money, they give investors far more diversification than buying individual issues. But the interest income and value of fund shares fluctuate on a daily basis, because bond funds never mature like individual bonds and because bond funds constantly buy and sell to reflect changing market conditions. That makes bond funds a shorter-term investment than individual bonds.