In case you didn’t notice, when stocks took their seasonal beating in January and early February, bonds held up beautifully.
In fact, Treasurys rallied, corporate bonds didn’t budge and municipal bonds emerged as the new favorite son of the market.
This is exactly what bonds are supposed to do. Their price stability, predictable returns and resilience to stock market drops make them the perfect holding for retired – and about to retire – investors who can’t afford losses or volatility.
[ad#Google Adsense 336×280-IA]Actually, I think they are the best thing you can do with your money at any age.
But that’s for another time.
Once you get over the bond market’s vocabulary curb, they are easier to understand than stocks and require about 1/100th the worry and nervous energy to own them.
If the price stability and the increased sleep factor aren’t enough to get you interested… and if the sell-off in January and early February wasn’t enough… maybe two of the lesser-known features of bonds will do it.
Sell and Still Get Paid
First, bonds have a little-understood aspect called accrued interest.
Most investors don’t realize it, but this unique quality of bonds makes them much easier to sell and even take profits on than income-producing stocks.
Here’s what I mean.
When you buy a stock that pays a dividend, you have to own that stock before or on the ex-dividend date to receive a dividend payment.
If you have to sell the stock before an ex-dividend date – which always seems to be the case – you will receive nothing for that dividend period.
However, because a bond accrues interest from the day you take possession, the person you sell the bond to has to pay you interest up to the day they took possession.
In other words, instead of having to wait until the next ex-dividend date to take profits off the table, you can sell the bond anytime you like and still get paid every penny in interest it has earned while you held it. And this is just one unique quality.
One other benefit bonds offer is what I call the MEAR, or minimum expected annual return. This allows you to know before you invest one cent exactly how much your minimum return will be if all you do is hold a bond to maturity.
A MEAR calculation looks like:
- All of the interest you will be paid until maturity
- Minus any accrued interest that is owed to the previous owner
- Plus any capital gain
- Divided by your cost and holding time.
Let’s look at an example of how to figure the MEAR for a bond that has five years to maturity – 60 months – purchased at a discounted price of $950 (that’s 95 in bond lingo), with a coupon of 7%.
For this type of bond you would receive 10 biannual interest payments of $35 each over five years. That’s $70 (7% of the $1,000 face value of the bond) annually divided by two.
You add to that your capital gain of $50 per bond – the difference between the $1,000 face value and the $950 we paid for the bond – minus our accrued interest, which, for this example, we’ll say is $10.
Then we divide by our holding time of 60 months and our price of $950. Then we multiple it all by 12 to get an annual return.
Let’s do the math:
10 x 35 + 50 – 10 / 950 / 60 x 12 = 8.21%
If all you do is hold the bond to maturity you will earn a minimum of 8.21% per year… and you know this before you invest one cent.
There is always the possibility the bond could run up in value before maturity, and we could sell it for a higher annual return. But, and this is the good part, no matter how low the bond drops in value before it matures, at maturity you receive $1,000 for it.
Now really, how much more can you ask for from an investment?
Stability, predictability and you make money from the day you buy it. Bonds truly are the best thing you can do with your money.
— Steve McDonald
Source: Wealthy Retirement