The Eight Great Misconceptions About Bonds

I’ve spent more time explaining bonds to clients than stocks, mostly overcoming eight great misconceptions about fixed income. I’ve found most advisors share those misconceptions. Here is how I explain bonds and correct those misconceptions.

What is a bond and why are they inversely correlated with interest rates?

Bonds are far simpler than stocks, alternatives, hedge funds, and derivative investments. A bond is a loan to either a corporation or a government and a bond fund is a collection of those loans. Say you lend a corporation $100 for 10 years at a 4% interest rate. You will receive $40 in interest and your $100 back. If, however, rates rise to 6%, you are getting $40 in interest while the market says $60 is the going rate. The value of the bond will decline. If rates fall to 2%, you are getting an extra $20 in interest over the market rate and the value of the bond will increase.

Far worse than interest rate risk is the chance of a default. If the issuer goes into bankruptcy, you will likely get no further interest and lose a good part of your principal.

Given that background, let’s look at the eight great misconceptions about bonds.