Q: I understand how bonds mature, but are they really safe? Can one lose with them, or can the bottom fall out of the bond market?
A: You ask an important question, because while bonds are generally a less risky part of a portfolio than stocks, there are several ways to lose money in bonds.
Here are some of the ways you can lose money in bonds:
- Issuer default. U.S. government bonds have the advantage of being backed by the federal government, but for other issuers you have to be concerned to some extent that the issuer could become insolvent and unable to pay the interest and/or principal on the bond.
- Buying at a premium. When bond yields are low, it generally means bond prices are high. With bond yields having been driven to extreme lows in recent years, many older bonds are trading substantially above par value. This means their principal will decline in value over time. The interest you earn should more than make up for it, but just understand that generally if you buy a bond at a price above $100, that price will decline as the bond approaches maturity.
- Selling before maturity. Even if you buy a bond at a price below par, you won't necessarily get your original investment back if you sell before maturity. Bonds are subject to up-and-down price fluctuations, so depending on when you sell, you could lose money.
- Investing in a bond fund. A mutual fund made up of bonds gives you the advantage of professional management, but it also subjects you to all of the above risks. In addition, in a bond fund you also have to overcome the management fee, which at today's very low yields is a real concern.
U.S. government bonds are the safest because they are virtually exempt from the first risk -- but they can still be subject to the other risks.
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