October 11, 2010

In part one I promised a (brief) review of bond market facts, so here it is:

Bonds are subject to two types of risk: default risk and interest rate risk.

Default risk is simple: if the issuer of the bond cannot or will not pay - they default and the bondholder does not get the interest or principal payment to which they were entitled.

Interest rate risk is a little more involved, but not much: if interest rates rise, the market value of a bond may fall. That is because most bonds carry fixed rates of interest. For example, if you own a bond paying 3% interest and interest rates rise to 10%, no one will want to buy your bond unless you sell it for a low enough price so that the buyer will earn a return in line with the market.

That's the bond market in brief. The good news for bondholders: no matter what interest rates do, your bond is a contract with the issuer. You will get the return promised when you bought it as long as the issuer does not default. And someday your bond will mature and - again barring default - you will get you principal back.

So unless a bond bubble is about default risk (hint: it's not) then who cares about a bubble? Is it a bubble if you can just hang on and get paid all of your interest and principal? In other bubbles (tech stocks, real estate, bank shares) most investors lost money. But if in the coming years interest rates rise and bond prices fall, some investors will lose big and some may not lose at all. I'll talk about why in part three.

GTC

(This article contains the current opinions of the author but not necessarily those of Brighton Securities Corp. The author's opinions are subject to change without notice. This blog post is for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities).