{"id":109652,"date":"2011-11-03T04:00:38","date_gmt":"2011-11-03T11:00:38","guid":{"rendered":"http:\/\/getrichslowly.org\/blog\/?p=109652"},"modified":"2023-12-06T10:56:25","modified_gmt":"2023-12-06T17:56:25","slug":"a-closer-look-at-bonds","status":"publish","type":"post","link":"https:\/\/www.getrichslowly.org\/a-closer-look-at-bonds\/","title":{"rendered":"A Closer Look at Bonds"},"content":{"rendered":"
It was more than a year ago that Wharton business school professor Jeremy Siegel, author of the classic Stocks for the Long Run<\/i><\/a>, co-wrote an op-ed in The Wall Street Journal called \u201cThe Great American Bond Bubble<\/a>.\u201d Siegel and Jeremy Schwartz caused a stir with their claim that the \u201cpossibility of substantial capital losses on bonds looms large.\u201d 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.<\/p>\n In an interview with IndexUniverse.com from last July, Siegel brought up the article<\/a>, saying, \u201cThat happened to be a nice call.\u201d 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.<\/p>\n 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.<\/p>\n First and foremost, remember that a bond is not like a stock<\/a>. Over the long term, the returns from bonds do not come from rising and falling prices.<\/p>\n 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.<\/p>\n 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 \u2014 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<\/i> rake in some cash by earning interest and reinvesting that interest; in other words, interest on interest. That’s known as compounding<\/a>, and it’s crucial to understanding the long-term returns from bonds.<\/p>\n Consider an example based on an illustration from The Bond Book<\/i><\/a> 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%.<\/p>\n 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:<\/p>\n<\/span>Price Doesn’t Necessarily Matter<\/span><\/h2>\n
\nCompounding returns make your money grow \u2014 like a group of guinea pigs!<\/i><\/div>\n<\/span>Compounding Matters<\/span><\/h2>\n