This is a guest post from Robert Brokamp of The Motley Fool. Robert is a Certified Financial Planner and the adviser for The Motley Fool’s Rule Your Retirement service. He contributes one new article to Get Rich Slowly every two weeks. In the past, I’ve illustrated some of Robert’s posts with cats. Today, I’m illustrating his article with some of the scrappy animals I’ve met in Peru.

Yawning Cat
Bonds may seem boring, but you need to know about them!

It was more than a year ago that Wharton business school professor Jeremy Siegel, author of the classic Stocks for the Long Run, co-wrote an op-ed in The Wall Street Journal called “The Great American Bond Bubble.” Siegel and Jeremy Schwartz caused a stir with their claim that the “possibility of substantial capital losses on bonds looms large.” If 10-year interest rates rose from 2.8% to 3.15%, bondholders would lose capital equal to the current yield. That’s because as rates rise, the value of existing bonds fall.

In an interview with IndexUniverse.com from last July, Siegel brought up the article, saying, “That happened to be a nice call.” Well, not really. Yes, stocks have outperformed bonds since the article’s publication in August 2010, but the average bond fund still made money. As for this year so far, stocks are down and bonds are up.

Yes, with rates so low, there are risks to owning bonds. But I find that there’s a good deal of misunderstanding out there. So before you sell all your bonds (if you own any), let’s take a look at how the market works and what could happen if rates rise.

Note: And before we even do that, it might be useful to review how bonds work or read about the basics of bonds. For many investors, bonds are a mystery. It doesn’t have to be that way!

Price Doesn’t Necessarily Matter
First and foremost, remember that a bond is not like a stock. Over the long term, the returns from bonds do not come from rising and falling prices.

For instance, consider a share of Coca-Cola stock, which traded for a split-adjusted $13.56 in January 1991. More than 20 years later, it trades for $67.04. Stock investors expect this type of price growth.

However, let’s say you bought a $1,000 20-year Coca-Cola bond in January 1991. How much was it worth when it matured in January 2011? Just $1,000 — the amount of principal that Coke returned to you. From a price perspective, you didn’t make any money for two decades. But you did rake in some cash by earning interest and reinvesting that interest; in other words, interest on interest. That’s known as compounding, and it’s crucial to understanding the long-term returns from bonds.

Cuy -- Guinea pigs being fattened for eating in Ollantaytambo
Compounding returns make your money grow — like a group of guinea pigs!

Compounding Matters
Consider an example based on an illustration from The Bond Book by Annette Thau. Let’s say you invest $10,000 in 30-year bonds with a 7% coupon (that’s the interest rate on a bond when it is issued). Like most bonds, these pay interest semi-annually, so you receive $350 every six months. You reinvest that money in an investment that also earns 7%.

During the first year, you receive two payments for a total of $700. However, reinvesting those payments gets you an additional $12.25. No big deal, right? Well, look at how interest on interest compounds over time:

Time Number of Payments Coupon Interest (Cumulative) Interest on Interest (Cumulative) Total Interest (Cumulative)
Year 1 2 $700 $12.25 $712.25
Year 5 10 $3,500 $605.99 $4,105.99
Year 10 20 $7,000 $2,897.89 $9,897.89
Year 20 40 $14,000 $15,592.60 $29,592.60
Year 30 60 $21,000 $47,780.91 $68,780.91

As you can see, the interest on interest of $47,780.91 is more than twice the amount of interest you actually received from the bond ($21,000) and almost five times more than your original investment ($10,000). This is all because you used the interest payments from your bonds to buy more bonds, which also paid you interest that allowed you to buy more bonds, and so on.

Now, you may be saying to yourself, “Sounds good, but that $350 I received as the first coupon — or even the $700 in the first year — wouldn’t have been enough to buy another bond, since most trade around $1,000. Plus, buying a single bond has relatively high transaction costs.” You’re right (goodness, you’re smart!). This demonstrates one of the values of bond mutual funds: The interest — even small amounts — is automatically and easily reinvested, commission-free. Furthermore, while most bonds pay interest semi-annually, most bond funds pay interest quarterly or monthly, which allows for faster and more efficient reinvestment.

As the table demonstrates, the dramatic payoff from compounding comes after two or three decades. But you can still see the benefits over shorter time frames. Consider someone who invested $10,000 in the Vanguard Total Bond Market Index Fund on Dec. 31, 1999. According to numbers provided to me by Vanguard, $10,000 would have purchased 1,046 shares of the fund.

Fast-forward to Dec. 31, 2010. Thanks to interest reinvestment, this person now owns 1,704 shares of the fund. The $10,000 investment has grown to $18,061 as of Dec. 31, 2010, mostly because the investor owns 658 more shares. Plus, even though rates have fallen since 1999, the total amount of interest this investor receives is more today than it was back then, because she has 63% more shares making distributions.

Patient Dog
Patience is a virtue — in the long run, bonds pay off

What If Rates Go Up?
So far, we’ve looked at a scenario in which rates stay the same and a scenario in which they drop. Now, let’s look at what might happen if and when rates go up — in fact, let’s assume they skyrocket by four percentage points. In a research report [PDF] published in 2010, Vanguard did just that, estimating the future returns on intermediate-term bonds if rates were to increase from 2.9% t o 6.9% — a 140% increase, steeper than any the U.S. has yet seen. Here are their projections:

  Today +1 Year +2 Years +3 Years +4 Years +5 Years
Yield (%) 2.9 6.9 6.9 6.9 6.9 6.9
Price change (%) 0 (18.4) 0 0 0 0
Total return (%) 2.9 (13.5) 6.9 6.9 6.9 6.9
Cumulative total return (%) (13.5) (7.5) (1.2) 5.7 13
Annualized total return (%) (13.5) (3.8) (0.4) 1.4 2.5

As you can see, the price of the bonds would drop an estimated 18.4% in the year rates begin to rise, but the decline would be offset by the interest payments, so the total one-year loss would be just 13.5%. Historically, the overall bond market has never suffered such a decline; the actual worst 12-month return for the Barclay’s Capital U.S. Aggregate Bond Index was a loss of 9.2% from April 1979 to March 1980.

Importantly, bonds now have a much higher yield, which helps the investment recover. As stated in the Vanguard report, “[T]wo years following the hypothetically worst bond market return ever, the diversified bond investor would be close to breaking even, simply by reinvesting interest distributions.”

Still, the 2.5% annualized return is lower than the 2.9% a year the bonds would have earned had rates not changed. It would be just grand if we could time the bond market, getting out before rates rise and getting back in when rates are about to fall. But that’s pretty hard to do. As legendary mutual fund manager Peter Lynch wrote, “Nobody can predict interest rates, the future direction of the economy, or the stock market.” 

Also, had the folks at Vanguard extended their analysis beyond five years, the annualized return would have exceeded 2.9% as several years of higher interest payments made up for the initial decline. In other words, higher interest rates eventually lead to higher returns. This is demonstrated in a table based on research from fund company Pimco:

Change in Interest Rates Return After 1 Year Return After 3 Years Return After 5 Years Return After 7 Years Return After 10 Years Return After 30 Years
+2% -1.7% 3.8% 4.8% 5.2% 5.5% 6.2%
+1% 1.6% 4.3% 4.7% 4.8% 5.0% 5.2%
No change 4.3% 4.3% 4.3% 4.3% 4.3% 4.3%
-1% 8.3% 5.2% 4.4% 4.1% 3.9% 3.4%

In this analysis, the starting yield on the bonds was 4.3%, and future returns are estimated based on a few scenarios. The scenario that produces the highest longer-term returns is the one with the highest spike in interest rates. As you know by now, this is partially thanks to the reinvestment of interest. But there’s one last point we must understand about how bonds perform after interest rates rise.

Rae talks with Julisa (and her lamb, Laurita)
Bonds can help safeguard your portfolio

Rising Prices, Guaranteed
Let’s return to how bonds differ from stocks. When the stock market is down, the right move may be to buy more shares in the hope that the market will eventually recover. But the stock investor doesn’t know when the recovery will occur. What will the stock market be worth five years after, say, a 10% drop? Who knows?

However, when an existing bond drops because of a rise in interest rates, the belief that its prices will rise again is more than a hope; it’s a certainty, as long as the issuer doesn’t default. For example, let’s say one of the bonds in your bond fund drops from $1,000 to $900 because of a rise in rates. Unless that bond defaults, it will definitely recoup that loss, gradually growing back to $1,000 as it nears maturity. Meanwhile, you’re reinvesting the distributions from your bond fund to buy more of these lower-priced, higher-yielding bonds.

The Bottom Line on Bonds
I don’t mean to downplay the risk of bonds right now. There is a real possibility — some say a likelihood — that rates will rise and the values of existing bonds will drop. And I agree with Siegel and Schwartz that, for the long-term investor, high-quality, dividend-paying stocks are a better bet than bonds at current rates.

But my concern is that all this talk of a “bond bubble” is scaring people into thinking that declines of 30% are on the way, causing investors to flee to non-yielding cash or buy stocks when they shouldn’t be taking on that much risk.

For money you absolutely need in the next three to five years, stick to short-term bond funds or a ladder of CDs. But for longer-term investments that aim to reduce the risk and volatility of your stock portfolio, a low-cost, high-quality, intermediate-term bond fund is still a good option.

Alpaca at Saqsaywaman in Cuzco, Peru
In general, bonds protection against stormy weather in the stock market