Contributed by: Nicholas Boguth, CFA®, CFP®
Some common verbiage was recently used in Bloomberg's newsletter: "Lock in yields!"
I never liked this phrase because it is a bit misleading for a few reasons:
Nothing in investing is "locked in". Returns are never guaranteed. That bond issuer MIGHT default. You might not get all those coupons, or worse, you might not get all your principal back. Inflation might eat away at that real return, too, but that is a topic for another time.
Many investors hear "locked in" and then forget about price movements. That coupon may be locked in, but if rates increase, then the price of your bond is going to decrease. This isn't necessarily a bad thing (you would be reinvesting at a higher rate, and alternatively, you can see your bond's price RISE if rates move down), but it is the nature of bonds and something investors need to be aware of.
If you buy a 10-year bond yielding 5%, you "locked in" $50 per year. $500 over ten years is closer to a 4.1% return annualized. So, did you REALLY "lock in" 5%? Sort of, but maybe not in the way that you thought. Total return on bonds also includes the reinvestment of the bond's coupons, so the path of interest rates over the bond's life matters, too!
You may think that a certain yield is attractive at a certain duration, but be sure to understand the risks that come along with all bond purchases, such as default risk (risk that you might not get your money back), interest rate risk (risk that your bond's price may move), reinvestment risk (risk that you might have to reinvest the coupons at a lower rate), inflation risk (risk that $50 now might buy you less than $50 in 10 years), and liquidity risk (risk that you may not be able to sell your bond easily when you want to).
Nicholas Boguth, CFA®, CFP® is a Senior Portfolio Manager and Associate Financial Planner at Center for Financial Planning, Inc.® He performs investment research and assists with the management of client portfolios.
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