Cents and Sensibility

Guy Steele

Drop in bond prices isn’t
a good reason to sell

IF you own bonds, you probably had a pretty good run in recent years, as prices remained strong. But when bond prices fall significantly, what does this mean to you? And how should you respond?

Before making any hasty moves, you may want to review just why bond prices have fallen.

As you may know, bond prices are inversely related to prevailing interest rates. So, let's say you have a bond that pays 6 percent interest.

Assuming then that there are new bonds of the same quality but only paying 4 percent, other investors will pay a premium to you for your bond. You can then sell it for more than its "par" (face) value. But if market rates rose to 8 percent, then the price of your 6 percent bond would drop, because no one would be willing to pay you the face value.

As someone who owns bonds, your initial reaction to these developments might be one of dismay. After all, who wants to see the value of their investments drop? But, upon closer inspection, you may find that the situation isn't as alarming as it appears.

Consider why you buy bonds. Was it because you thought their price would rise and you could then sell them for a profit? Probably not. If you're seeking capital appreciation, you should consider buying growth stocks. However, keep in mind that stocks have higher risks including the potential loss of principal invested.

But you do have at least three good reasons to invest in bonds:

>> Current income. By investing in bonds, you receive a regular, predictable income stream. If you feel the income is too low, you might be able to boost it by building a "bond ladder" -- a collection of bonds of varying maturities. That way, when market rates are low, you'll still have longer-term bonds paying higher interest. And, since you'll continually have maturing bonds, you'll always have money coming in to reinvest, which works to your advantage when market rates are high.

>> Protection of principal. When you buy government bonds, you will be receiving the highest quality of bonds. And the timely payment of interest and principal is guaranteed by the U.S. government. When considering corporate or municipal bonds look for those that are "investment quality," which are bonds that receive the highest grades from independent rating agencies.

>> Portfolio diversification. If your portfolio is overwhelmingly tilted toward equities, you may find that bonds can provide you with some valuable diversification. Keep in mind that stocks and bonds frequently move in different directions; so, if the stock market is slumping, your bonds can help cushion the impact.

You will note that all these benefits hinge on your holding your bonds until maturity. Is there ever a good reason to sell bonds before they mature?

Yes, if your portfolio has become "unbalanced."

Specifically, if bonds make up such a large percentage of your holdings that your growth objectives are threatened, you might want to consider selling some of those bonds. (There may be tax consequences and transactions costs associated with taking this action.)

Other than that, though, you'll want to hang on to your bonds. And, as long as you know that's what you're going to do, you'll find it much easier to cope with the occasionally sharp price fluctuations of the bond market.

See the Columnists section for some past articles.

Guy Steele is a financial planner and head of the Pali Palms office of Edward Jones. Send planning and investing questions to him at 970 N. Kalaheo Ave., Suite C-210, Kailua, Hawaii, 96734, or call 254-0688


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