Is it a Bad Idea to Buy Bonds When Interest Rates are Going Up?

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Here’s something I bet you didn't know. The size of the U.S. stock market is about $30 trillion. If you added up the value of all publicly traded stocks in the U.S., the market value of all those companies would come up to around $30 trillion, but what about bonds?

Bonds are hardly ever mentioned or talked about in the financial media, but I bet you might be surprised to discover that the U.S. bond market is actually much bigger than the stock market. The U.S. bond market is estimated to be $40 trillion or more. That's right, the bond market is actually larger than the stock market and yet the financial media has almost all their attention and therefore our attention on the stock market.

So what about bonds? Should you be buying bonds when interest rates are going up? You may have heard that when interest rates go up, bond values go down, which is true. Think of a seesaw or a teeter totter, the end that goes up is interest rates and the end that goes down is the underlying value of the bond.

Bonds by the way are nothing more than a loan to a company, government or government agency. Typically, bonds pay their interest twice a year, every six months, and when the loan comes due, they have a maturity date which could range anywhere from 90 days to 30 years, when you get your money back.

If you look at long term returns of investments, let's say a 15-year timeframe or longer, then it's no secret stocks have outperformed bonds by a large, large margin. So if stocks do better than bonds over the long term why not just have all of your money in stocks?

Well, the problem is while stocks tend to deliver nice, long-term returns, the short term could be a whole other story. Stocks on the short term can be extremely volatile. Just look what happened in the financial crisis of 2008. The S&P 500, the 500 largest publicly traded companies in America, lost about 38 per cent in value. So, $100,000 in the S&P 500 at the end of 2008 was now worth $62,000. Ouch! That's a lot of short-term volatility which tends to make you and I uncomfortable, to say the least.

So how do we dampen or minimize that volatility? Imagine you have a sailboat and you have entered it into a race. One way to make your sailboat go faster is to make it lighter. But the lighter the sailboat, the more likely it is to capsize with a gust of wind.

To prevent that you add weight or ballast to the sailboat. That slows the speed of the boat, but it reduces the odds of the boat capsizing and sinking. This is how you should think of bonds in your overall investment strategy. They are going to slow down the overall growth of your investment accounts, but they are there to keep you from capsizing, to keep you from sinking during short-term periods of market volatility.

So, the answer to the question should you buy bonds, even when interest rates are going up, as a long-term investor, the answer is a qualified yes, and here's what I mean by that.

If you buy individual bonds and hold the bond until it matures or is called away early by the issuer, then you'll receive the interest and get all your money back when the bond matures. The value of the bond can and will fluctuate while you own it, but it doesn't affect you if you hold it to maturity because then you get all your money back.

This is why it's important to own individual bonds, especially in a rising interest rate environment, you don't lose money if you hold the bond until maturity.

Why not just use a bond mutual fund? The problem with a bond mutual fund is it doesn't have a maturity date. People are constantly adding or withholding money from the mutual fund itself and typically at the wrong time. In a rising interest rate market, a lot of people in bond mutual funds take some or all of their money out of the mutual fund which forces the mutual fund manager to sell bonds even if they didn't want to. They have to generate the money to pay back the investors and that could drive the value or the price of bonds down even further. Ideally, you want to use individual bonds so you know for sure you get your money back when the bond matures.

If you have a small account, and I would say a small account would be $200,000 or less, then you may not have enough money to properly diversify into individual bonds and you may have to still use bond mutual funds and if that's the case in a rising interest rate market you want to focus on short term bond funds or floating rate bond funds.

Buying individual bonds as part of your investment strategy will help you move one step closer to experiencing your version of an incredible retirement doing what you want, when you want.

Brian Fricke