Money In Pocket

Bonds can put a steady flow of money in your pocket, but make sure you know what you're buying.

There are several things many investors "know" about bonds that simply aren't true. For example, junk bonds aren't necessarily high-risk investments -- nor are "safe haven" bonds such as Treasuries invulnerable to drops in value. With that in mind, here are three common misconceptions about bond investing that our experts want you to be aware of.

Eric Volkman
Because of their infamous nickname, junk bonds have an awful reputation, which is why issuers and brokers refer to them as "high-yield" bonds instead.

As the more flattering terminology implies, these bonds typically pay out much more than their peers, because their debt is rated below "investment grade" -- that is, the higher tiers of the ratings doled out by Standard & Poor's, Moody's, and other credit rating firms.

But there are a lot of reasons a company might not have the best credit profile. It may be the vehicle of an activist investor who likes taking big stakes in cyclical energy stocks, as is the case with Icahn Enterprises. Or it might operate in a capital-intensive industry that mandates constant investment, such as Fiat Chrysler. Both companies are making money: Between them, they've posted only one annual fiscal-year net loss over the past half-decade.

Meanwhile, Moody's puts the default risk of junk/high-yield bonds at only 1.7%. That's awfully low for instruments that are commonly perceived to be perpetually on the verge of collapse.

Make no mistake: These bonds are riskier than Treasuries or your favorite blue-chip company's latest chunk of debt. But they're not necessarily the money-destroyers that their derogatory nickname implies.

Matt Frankel
Possibly the most common myth about bonds is that they're completely safe investments. That's simply not the case -- especially when it comes to long-dated bonds.

For one, all bonds carry some level of credit risk. If the issuer (a company, government, or what have you) has its credit downgraded, then investors will expect to receive a higher yield to make up for the increased risk, and prices will go down.

Bonds are also susceptible to interest-rate fluctuations, especially when we're in a low-rate environment as we are now.

For example, let's say you buy a 30-year Treasury bond for $1,000, with an interest rate (or coupon rate) of 2.9%, which is the market rate as of Aug. 6. Let's say that over the next two years, 30-year Treasury rates rise to 4.5%, which would still be rather low on a historical basis. Well, since your bond pays much less than investors expect, the intrinsic value would drop to approximately $744. Now, there's not a perfect up-and-down correlation, as you'll still get the original $1,000 back upon maturity, but it is a significant concern.

To illustrate this point, consider how various interest-rate increases over the next two years (28 years to maturity) could affect the value of a 30-year Treasury bond with a 2.9% coupon rate.

If Interest Rates Spike to...

A 30-Year Treasury Bond Would Be Worth...

4%

$814

4.5%

$744

5%

$682

6%

$579

Of course, it doesn't matter much if you plan to hold your bonds all the way until maturity, but if there's even a slight chance you'll need the money sooner, you need to be aware that bonds can lose quite a bit of their value.

Dan Caplinger
There's a lot of confusion about how bond mutual funds and ETFs compare with individual bonds. Some people think that individual bonds are far preferable to funds, arguing that if interest rates rise, then you can always hold an individual bond to maturity and get your principal payment, while funds can sometimes permanently lose value.

It's true that if you fully intend to hold bonds to maturity, then you can essentially ignore price volatility along the way. But it's still important to recognize that at any moment in time, rising rates hit the fair market value of an individual bond just as much as they do a bond fund. Moreover, with an individual bond, if rates rise, you're stuck with your subpar interest payments until maturity. With bond funds, however, rising rates eventually work their way into higher dividend payments, which can then offset any permanent drop in the fund's net asset value.

Holding individual bonds can be a great way to earn income, but you shouldn't automatically assume that bond funds are fundamentally worse. The two types of bond investments react differently to changing conditions, but the end result from both is more similar than you might realize.

Dan Caplinger has no position in any stocks mentioned. Eric Volkman has no position in any stocks mentioned. Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.