One of the first things an early or new investor is typically told is that bonds are safer than stocks but will offer lower capital appreciation than stocks. Or in simpler terms, bonds are less risky, and, therefore, they offer a lower reward. But in reality, these things we are taught about a bond's risks are not always true, depending on how you are invested in the bond, bonds, or a bond ETF.
Most people speak of the risk profile when they are talking about low risk. Low reward bonds is a scenario when the investor holds the individual bond themselves. Like stock ownership, a bond investor can buy individual bonds and hold them in their portfolio.
Let's quickly look at how and why bond prices change before we go any further. Say you buy a 1-year bond for $980.00, and when it matures in a year, it will be worth $1,000, meaning the bond you bought is yielding a 2% rate of return. Now let's say you hold the bond for the full year; you will make your 2% or $20 and be happy. Your only risk in this scenario is that whoever sold you the bond defaults on it, which for this example, is probably not likely. (The higher the interest rate on the bond at the initial time of sale typically indicates how risky the bond is and how likely the bond seller is to default. 2% is a very low risk in normal market conditions.)
If you plan to hold and ride the bond to mature, bonds are very low risk, as we have all been taught. However, if you plan to sell the bond before maturity, you are increasing your risk. For example, when you own the bond we spoke about above, that is paying a 2% rate of return, if the current market is demanding say a 4% rate of return on bonds, then to sell your bond, which you paid $980 for, you would have to offer another investor a 4% rate of return, or sell the bond at $960, so the buyer could realize a 4% rate of return, which is the current going rate for a bond if they held the bond to maturity. Continue reading "The Problem With Bond ETFs Right Now"