By timestaff
March 11, 2008

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Question: If I invest some of my money in bonds for retirement, what penalty would I pay if I had to sell some of those bonds? –Terri

Answer: Winston Churchill once famously described Russia as “a riddle wrapped in a mystery inside an enigma.” As far as many individual investors are concerned, he might have been talking about bonds too.

And indeed these days the bond market is even more confusing than usual, what with cross currents ranging from subprime mortgage problems to the threat of recession to the possibility of renewed inflation sweeping through the market.

So I’m happy to answer your question and at the same time try to provide some broader advice about steps you and other individual investors might take to navigate today’s challenging bond market.

Let’s start with a quick recap of what bonds are and how they work.

Basically, a bond is an IOU. When you buy a bond – whether it’s a Treasury, corporate or municipal bond – you’re essentially lending money to the issuer who agrees to make interest payments and repay the principal, or face amount of the bond at the end of its term.

The risks

When you invest in bonds (or bond funds, for that matter), you take two risks. One is called credit risk, which is the possibility that the bond issuer might not be able to make required interest payments or repay the principal value at the end of the bond’s term.

That’s not a problem with Treasury bonds, since Uncle Sam can always tax us to come up with the dough to make good on the bonds. But this is a risk with other types of bonds. Today, investors are particularly jittery about credit risk in part because some bonds are backed by pools of mortgages whose value has become suspect because of problems in the credit and housing markets.

The second risk bond investors face is called interest-rate risk. Think of a seesaw with interest rates on one side and bond prices on the other. When rates go up, bond prices go down.

This inverse relationship makes sense when you think about it. Let’s say I buy a 10-year bond for its face value of $1,000 that pays 5% annual interest, or $50 a year. And let’s assume that right after I buy the bond inflation fears push up interest rates so that a similar 10-year bond issued at a $1,000 face value the very next day has to pay 6% annual interest or $60 a year. Clearly, the value of my bond would fall below $1,000. After all, who would give me a thousand bucks for 10 payments of $50 a year plus the return of the $1,000 face value when for the same thousand dollars they could get 10 payments of $60 a year plus the return of the $1,000 face value?

Which brings us back to your question: if you wanted to sell your bonds what sort of penalty might you pay?

Well, you wouldn’t actually pay a penalty in the same sense that a bank charges a penalty for cashing in a CD early. Rather, the amount you would receive for your bond would depend on its market value.

If bond investors were concerned about the issuer’s ability to pay interest and principal – or they had questions about the value of assets backing the bond – then you might get less than you paid for it. How much less is hard to say. That would depend on how serious other bond investors viewed the problem.

But even if there were no credit concerns, you might get less than you paid for your bond if interest rates have climbed since you bought it. How much less depends on a number of factors, including the bond’s maturity date and its “coupon,” or the annual fixed rate of interest the bond.

In the case of interest-rate risk, it’s a little easier to estimate how much you might lose because there’s a nifty little stat called duration that gives you a good sense of how sensitive a bond is to changes in interest rates. If a bond has a duration of, say, 8 years, then its price would drop roughly 8% for every one-percentage point increase in interest rates.

The broker who sold you the bond should be able to give you its duration. You can also estimate the duration of a bond with this calculator. And by going to the InvestinginBonds site, you can also check the recent trading prices of government, municipal, corporate and mortgage-backed.

You’ve asked about a penalty, but you should also know that credit and interest-rate risk could work in your favor. If a bond issuer’s creditworthiness improves after you bought the bond, you might get a higher price than you paid. Similarly, if interest rates fall, the price side of the seesaw would rise, lifting the bond’s price. In fact, if the bond has a duration of 8 years and rates fell by one percentage point, then the bond’s price would rise by about 8%.

How to invest

One thing you didn’t ask about but I think is important to bring up anyway is whether you should be in individual bonds, as opposed to bond funds.

My take on that is that if you really don’t know your way around bonds – and I’ve only scratched the surface here – you shouldn’t buy individual issues. There are too many ways to make costly mistakes in the bond market, like the very real possibility of dramatically overpaying for what you get.

And even if you do consider yourself an old bond hand, you’re still probably better off in funds unless you’ve got enough moola to build a diversified portfolio of individual issues. Reasonable people can disagree about how much you need, but I’d say you should have $50,000 or more to invest in individual bonds.

If you do go the fund route, I’d recommend sticking mostly to funds that invest in high-quality bonds and keep the average maturity in the short- to intermediate-term range, or four to seven years. I think that’s a smart strategy – especially given all the concerns today about credit quality and a possible uptick in inflation.

You can always try fancier strategies, of course. Just be aware that if things go wrong, you could end up having to take a loss on your bonds or bond funds if you sell.

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