With bonds at all-time lows and interest rates constantly in the media, there's a lot of misinformation going around. We asked our Motley Fool experts to separate facts from myths in the bond world. Here's what they had to say.
One big myth accepted by many people is that you can never lose money owning a bond or a bond fund. That myth comes from the idea that bonds are less risky than stocks and are thus a safe haven for those who don't want the risk of the stock market.
Yet bonds have their own risks. Interest rate movements change the value of bonds, and bonds with a long time horizon to maturity can experience big price swings even from small interest rate movements. Those fluctuations will affect how much you can get if you sell an individual bond before maturity. Bond funds can be even worse, as they typically don't have a set maturity date, so you might never earn back lost principal even if you hold the fund for years.
Moreover, when a business fails, bondholders often take a financial hit. In the final payouts, bondholders do have a spot in line ahead of shareholders, who are typically wiped out in bankruptcy and insolvency situations. But even some bond investors end up getting only pennies on the dollar, making it important for those who choose bonds other than government-backed Treasuries to look closely at the creditworthiness of the issuer before investing in its bonds.
One prevailing myth is that municipal bonds are completely tax-free and risk-free.
The one key benefit to municipal bonds is that their income is generally not subject to the federal income tax. However, income from municipal bonds might be taxable at the federal level under the alternative minimum tax. Furthermore, income from municipal bonds could still be taxed at the state and local levels depending on your state. Many states exempt resident stakeholders from taxation on that state's municipal bonds but still tax holders of out-of-state municipal bonds. In all cases, capital gains from selling a municipal bond or bond fund are taxable.
When it comes to risk, defaults are rare but not unheard-of for municipal bonds. Bondholders should note that municipal defaults have concentrated in the housing and healthcare sectors.
As investment prospectuses everywhere read, past performance is no guarantee of future results. As many American cities' finances continue to worsen we will likely see more defaults similar to what happened with Detroit. If you aren't an expert, I recommend buying bond funds or exchange-traded funds, rather than individual bonds.
Index funds revolutionized stock investing by making it possible to buy hundreds of stocks yet pay only one inexpensive fee. When it comes to bonds, however, you may want to stick to actively managed funds.
Actively managed bond funds generally don't charge much more than a passive or indexed bond fund. Whereas the passive iShares High Yield Corporate Bond ETF (NYSEMKT:HYG) has an expense ratio of 0.5%, BlackRock's High Yield Bond Fund (BRHYX) recently reported a total expense ratio of 0.52%. The small difference is a price worth paying, particularly given that the actively managed fund has handily outperformed its benchmark.