Bond funds make bond investing easy for average investors. Investing in bonds profitably could soon be a different story. The hazards of bond investing follow in no uncertain terms, in plain simple English.

The attraction of bond investing is that bonds pay the investor higher interest income than other investments. These securities represent long term debt to the issuer, which is usually a corporation or government entity. Example: XYZ issues bonds priced at $1000 each which pay $60 a year in interest and mature in 20 years. At maturity whoever owns that bond security gets the $1000 back and the security no longer exists. Throughout its 20-year life, the bond trades in the secondary market and its price fluctuates. Any investor who owns it can sell at will at the market price; and an investor in search of income can buy it in the bond market. Note this: the $60 a year in interest income is FIXED for the life of the bond and never changes. This gives you a 6% yield.

Now you know bond investing basics. Few average investors actually invest in individual bond issues like XYZ above. Instead, millions of Americans get into bond investing the easy way with bond funds. These funds pool investor money and manage a collection (portfolio) of these securities for their investors. When you invest money in a bond fund your money buys shares, and you then own a small part of a large portfolio of bonds. The fund actually owns the securities and buys and sells bonds on an ongoing basis. They pass the interest income on to investors in the form of dividends, and usually charge less than 1% a year for their services.

As a bond fund investor you can have your interest income send to you periodically or you can have these dividends reinvested automatically to buy more fund shares. The value or price of your shares will fluctuate along with the price fluctuations in the individual bonds held in the portfolio. You can buy or sell fund shares on any business day. You're not locked in. Now you know bond fund investing basics. So, here's the rest of the story. Remember, when you own bond funds you have an investment in bond securities. Whatever happens in the bond market and to the value of the bonds in your fund portfolio translates to gains and losses for you.

Let's say you own shares in the most popular type of bond fund, an intermediate-term fund of high credit quality. The average bond security in the portfolio matures in a little less than 10 years. The fund is paying a dividend yield of 6%, and you're happy with it vs. the 2% interest you might get from your bank. What could go wrong? Interest rates could go up. A couple of years from now new bond issues could be paying $90 a year in interest income for a $1000 bond, which translates to 9%. What do you think will happen to the price (value) of a 6% bond when investors can get 50% more interest income in new bond issues (9% vs. 6%)? The price will fall substantially for all existing bonds, including those in your bond fund.

Let's put it this way: If you pay $667 for a bond that pays $60 a year in interest income you earn a current yield of 9%, because 9% of $667 equals $60. If 9% is the new going rate, any interested investor can either buy a new issue to get it or pay a reduced price (get a discount) for an existing issue in the bond market. Remember, bond prices fluctuate as these securities trade in the market.

Don't dwell on the math if it confuses you, and please note that the above example suggesting that a 6% bond originally issued for $1000 paying $60 a year could fall to a value of $667 if rates for new similar bonds increase to 9%. It's an oversimplification to emphasize this concept: the most important thing you must know about bond investing these days is that bond investors will lose big when interest rates go up significantly. When interest rates go up bonds and the bond funds that invest in them lose money, and so does the investor.

A retired financial planner, James Leitz has an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly with them helping them to reach their financial goals.

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