Want to loan your money to governments and businesses across the globe? It’ll take you two minutes: just buy a Total U.S. Bond Market Index Fund, along with a Total International Bond Market Index Fund, and you’ll be loaning money to nearly every government and publicly-traded company in the world.

Okay, But What’s a Bond?

A bond is a loan to a government or company, with a regular interest payment during the loan duration and repayment of your principal at the end of the loan. You can loan your money to the U.S. government (Treasury bills, notes, and bonds), local governments (municipal bonds), foreign governments, or U.S. and foreign businesses (corporate bonds). You can also loan your money for the short-term (less than 1 year, up to 5 years), intermediate-term (5-10 years), and long-term (10+ years). And for corporate bonds, you can lend money to strong companies with good credit ratings (called high-quality bonds), or to weaker companies with poor credit ratings (called “junk bonds”) that need to offer higher initial yields to entice investors.

Bond Basics

If you buy an individual bond, say a Treasury note, with a face value of $1,000, a 5% interest payment (called the “coupon”), and a 5-year duration, then you’ll receive $50 per year for the next 5 years, at which time the U.S. government will pay you back the original $1,000. The maturity date is the date in which the bond is retired, and you’re paid back your principal.

The Interest Rate/Bond Price Teeter Totter

It’s counterintuitive, but the price of a bond moves in the opposite direction as interest rates. For example, let’s say that you invest $1,000 in a 5-year bond that yields 5% and the very next day interest rates jump to 10%. What happens if you want to sell your bond on the secondary market? Do you think someone would pay you $1,000 to buy your bond that throws off $50/year, when they could invest $1,000 in a new bond that will pay them $100/year? No way. But they will pay you $500 for your bond, because then the current yield of both bonds is the same. (The yield is just the cash flow divided by the bond price; $50/$500 = 10% and $100/$1,000 = 10%). The upshot is that your bond price has declined by 50% on the secondary market because of the interest rate change.

So, if interest rates go up, bond prices decline. If interest rates go down, bond prices increase.

Individual Bonds: Total Return = Yield

In the above example, if you bought an individual bond (and not a bond mutual fund), all you have to do is keep your bond the full five years, at which time you’ll be repaid the original $1,000, regardless of what happened to interest rates along the way. When you buy an individual bond and hold it for the full duration, you’ll never have a capital gain or loss; your total investment return will simply be the yield (i.e., interest payments), assuming the government or business does not default on the loan.

Bond Mutual Funds – A Peculiar Issue

Bond mutual funds, however, have a peculiar issue. Since a mutual fund is simply a basket of many different bonds, laddered with differing durations and maturity dates, the fund essentially has a perpetual maturity, because the fund purchases new bonds as the old ones sunset. So, a bond mutual fund has a perpetual, rolling maturity. Remember, if interest rates go up, bond prices decline. If interest rates rise quick enough, the decline in price could overwhelm the interest payment, meaning you will lose money on your bond mutual fund for that year. So be aware that bond mutual funds can sometime have a negative total return in a rising interest rate environment. As bonds held by the mutual fund come due, though, the fund will be able to reinvest in new bonds at the higher interest rate. This will dampen the price decline of bond funds in a rising interest rate environment, especially for short- to intermediate-term bonds. The reverse can happen as well. A decline in interest rates will cause the price of a bond mutual fund to rise, but the fund will be forced to reinvest in new bonds at the lower interest rate.

Long-Term Bonds Are Most Peculiar

Long-term bond prices are much more sensitive to changes in the interest rate, with relatively large price swings in response to a change in interest rate compared to short- and intermediate-term bonds. This is fine if interest rates are on the decline, but it’s painful to own long-term bonds in a rising interest rate environment. The best time to buy long-term bonds is when interest rates are high, for two reasons: (1) the bond yield is relatively high, which can be locked in with longer duration bonds, and; (2) interest rates will likely go down, which means the price of your bond will increase. Of course, your principal will be worth much less down the road, due to inflation, when the long-term bond comes due, and you’re paid the principal back. What about a rising interest rate environment? Short-term bond mutual funds are your best bet.

Bond Mutual Funds: Total Return = Yield + Capital Gain

What is the expected total return for a bond mutual fund? In terms of the yield, take the initial yield and subtract out a certain percentage for defaults. For example, a U.S. government bond has essentially no default risk, so your expected yield is equal to the initial yield. For an investment-grade corporate bond mutual fund, the yield is the initial yield minus a small percentage for defaults (i.e., companies that go bankrupt and can’t pay off their loans). Under normal conditions, subtract about 0.5% for defaults for investment grade bonds, so your expected yield is the initial yield minus maybe 0.5%.

For high-yield (”junk”) bonds, expect to subtract more than 0.5% for defaults, maybe around 1% to 2% during normal times, as high-yield bonds represent weak companies that are on shaky ground. These companies need to offer higher initial yields to induce investors into loaning them money. (This discussion applies only to bond mutual funds, which is a basket of many bonds. Your default risk is much higher if you hold a bond from a single company – just ask someone who had their retirement savings in a General Motors bond in 2008.)

To the yield, add the capital gain/loss resulting from bond price increase or decrease due to changes in interest rates. Your total return, then, is the sum of the yield and capital gain. So, for a bond mutual fund, the lesson is to keep your eye on the total return, which is the yield (net defaults) plus or minus capital gain/loss that results from changes in interest rates.

So, What to Do?

At the end of the day, the key to bonds is to keep it high quality and short in duration (less than 1 year, up to 5 years) in a rising interest rate environment. Consider buying long-term bond funds if interest rates are unusually high and likely to fall in the future. If you want to just set and forget your portfolio, invest in a short-term bond index fund (i.e., Short-Term U.S. Bond Market Index Fund) and let it ride.