Editor’s note: Due to technical difficulties, the Chamberlin On Money column wasn’t available this week. This is a reprint of an older column.
Dear George: What happens if I buy a U.S. Treasury bond and interest rates go up? What will happen to the interest rate on my investment?
, Larry, San Diego
Dear Larry: Your question goes right to the heart of bond investing. Understand the market fluctuations in the bond market can be as difficult as dealing with the volatility in the stock market.
A bond is basically an IOU. You lend your money to an entity , like a corporation or government agency , and in return you are paid a certain rate of interest over a described period of time. So far, so good.
Things get a little dicey when you realize that bonds are negotiable investments that can be bought or sold at any time before their ultimate maturity. Let’s assume you buy a bond that matures in 30 years and pays an interest rate of 6 percent. If it is your intent to hold that bond for all 30 years you don’t have to worry about any changes in the market value of your investment. But, what if you have to sell it before maturity?
Bond prices react in an opposite manner to the movement in interest rates. If interest rates go up after you purchased the bond then its market value will decline. Obviously a bond yielding 6 percent is not as valuable as a bond yielding 7 percent. The only way you can equalize the return on the bond is to reduce its price. Conversely, if interest rates decline after you buy a bond its market value goes up. Again, none of this is important if you hold the bond to maturity. You will get back the full value of your investment.
Once you purchase a bond your interest rate remains constant. Again, the principal may fluctuate but the interest is fixed.
One of the reasons I usually shy away from bond mutual funds is because neither your principal nor interest rate are guaranteed. Funds do not have maturity so the possibility exists that you may never be able to get out of the investment with what you put into it. And, the interest rate you receive on a bond fund will slide up and down depending on changes in the market.
Bonds are good investments for income-oriented investors. But, to be sure, they can be very risky investments.
Dear George: What is the difference between a balanced mutual fund and a growth and income mutual fund?
, Hank, Oceanside
Dear Hank: Many investors assume these types of funds are one and the same, however, there is a significant difference.
A balanced mutual fund invests in a combination of stock, bonds, and cash equivalents.
The manager is given the ability to determine the proper asset allocation for the portfolio based upon current investment conditions. On the surface this seems like a good idea. However, my experience with balanced funds has been less than profitable. It seems that the people who manage these funds are a wee bit paranoid. As a result they wind up being in the wrong place at the wrong time. If you want the benefits of both a stock and a bond fund then buy two separate portfolios.
A growth and income fund invests in common stocks that offer a modest dividend. No bonds are included in the portfolio. Even though there is a reference to income, you will never generate much cash flow off one of these portfolios. The current yield on the S & P; 500 is well below 2 percent and most growth and income funds don’t even generate that much. The dividends on these stocks provide an accelerator when prices are going up and a cushion when prices are falling. I have always liked these funds.
Chamberlin is the host of “Money in the Morning,” heard weekdays from 9 a.m. to noon on KSDO.Com AM 1130. Send letters to P.O. Box 1969, Carlsbad, CA 92018, or E-mail him at (george@moneyinthemorning.com).
