Most investors understand the concept of diversifying their portfolio between stocks and fixed income investments (bonds), especially as you get older. However, many investors, even those who own fixed income investments, don't understand some of the most important concepts about them.
Specifically, BlackRock conducted a survey of Americans with over $50,000 in investable assets, and only 43% said they had a good understanding of the market and economic forces that drive bond prices. What's more, many survey respondents didn't know two very important fixed income concepts that all investors should know.
You can lose money with fixed income investments
Nearly one-third of survey respondents, and a surprising 44% of people who considered themselves to be knowledgeable about fixed income investing, incorrectly believe that you can't lost money with fixed income investing.
This is completely false, and is important for fixed income investors to understand. All bond investments carry some degree of default risk.
While certain types of bonds are less prone to default than others, the risk is always there, and there are many levels of default risk. For example, U.S. Treasury securities have an extremely small (but not zero) risk of defaulting, while corporate bonds are only as strong as the company that issued them. Knowing how to interpret bond ratings can help you assess how risky your bonds are.
In the event of bankruptcy, bondholders to have priority over common and preferred stockholders when it comes to recovering some of their investment. Even so, if a company that issued bonds goes bankrupt, it's quite common for bondholders to only recoup a few cents on the dollar of their original investment.
A smart way to avoid losing money on fixed income investments is to buy bond funds as opposed to individual bonds. With a fund that holds millions or billions of dollars' worth of bonds, even if a few of them end up defaulting, it won't wipe out your investment.
Furthermore, your bonds can lose value over time in certain circumstances, which I'll discuss in the next section.
Rising interest rates are bad for fixed income investments you already own
Are rising interest rates good or bad for bond investments that you already own? In BlackRock's survey, only 31% of respondents answer the question correctly, that rising interest rates cause bond prices to fall. The rest (including 64% of those who said they were knowledgeable about fixed income investments) either said that rising interest rates would have a positive or neutral effect on the market prices of their bond investments.
To be clear, changes in interest rates have no effect on the income you receive from your bonds. It is based on your bond's face value and stated interest rate or "coupon rate," and remains the same throughout the life of the bond. However, the value of your bonds can change in response to changing interest rates.
To illustrate this, let's say that the current market interest rate for 30-year Treasury bonds is 4%, so you buy one for $1,000 that pays you $40 in interest each year.
Now let's say that the market interest rate spikes to 5% shortly after you bought your bond. With the higher rate, investors now expect a 5% yield on their bond investments. So, in order for your bond, which pays $40 in annual interest, to generate a 5% yield, the bond's market price would have to drop to roughly $800.
This is certainly a simplified example, and the effect is less dramatic on fixed income investments of shorter maturities, but this is the basic principle that applies when interest rates rise. And conversely, if rates fall, bonds you already own will be worth more.
The Foolish bottom line
Bonds can be great investments for income seekers and those who want to reduce volatility in their portfolios. And as I've written before, they should be a part of all well-diversified portfolios.
However, it's important to realize that bonds are not risk-free investments, nor are they immune from going up and down in value over time. The more you understand about your bond investments, the better-equipped you'll be to make smart investing decisions and to react to economic changes.