Editor’s Note: If someone had told me that understanding bonds was a lot like understanding wine, I would be an expert at this point.
That’s what Steve is aiming for in his monthly bond basics series – to educate you about bonds so that you can make better investments. (The wine part is all up to you.)
In today’s piece, he discusses maturities and how – just like your favorite bottle of red – bonds get better with age.
Pour yourself a glass and start reading…
– Amanda Tarlton, Assistant Managing Editor
One of the many benefits of owning bonds is that they provide a solution to one of the biggest reasons small investors lose money: They don’t have a workable exit strategy.
You can do all the legwork and own the best investments on the market… but if you don’t have an exit strategy, you’re finished before you start.
Bonds are unique in that they have an automatic, hands-off sell system: their maturity date. That takes care of the most difficult decision in the money world (when to sell) for you.
This fixed exit date also allows a bond owner to know – to the penny and to the day – the minimum they will earn and exactly when they’ll receive their payoff. And they don’t have to do a thing to realize their returns.
No other investment offers that kind of control and predictability.
Here’s an example of a bond’s maturity and how this works.
(Don’t buy this bond; I am not recommending it. This is just an example.)
CBL Properties, a mall and shopping center owner and developer, has a bond that matures on December 15, 2026, and pays a coupon of 5.95%.
The interest will be paid in two equal payments on June 15 and December 15 every year until the maturity date. On that day (December 15, 2026), you are out of the bond and, no matter what you paid for it, you get back $1,000 in principal.
The trade is done; you received all your interest and got your principal back.
And it all happened automatically.
Besides, as good as an automatic exit strategy is, controlling the maturity of your portfolio has three more advantages.
First, focusing on maturities allows you to control the market volatility of bonds driven by increases in interest rates.
The shorter the maturity of a bond, the less it fluctuates in value when market forces drive rates up.
And after eight years of almost zero interest rates, there shouldn’t be any question of where rates are going…
Bond prices, unlike stock prices, don’t usually move up and down much. If you keep your average maturities short (five years or less), you will eliminate most, if not all, of any potential price movement due to rate increases.
Second, controlling market prices reduces how much your account value will drop in a sell-off. That helps eliminate the account balance shock that drives panic selling.
Lastly, shorter maturities limit how long your money is exposed to the effects of inflation. The less time you hold any fixed-rate investment, the less time inflation has the opportunity to erode the buying power of your principal.
Inflation hasn’t been much of a problem for the past few years, but it is back. And, if left unchecked for extended periods, it will devour your nest egg.
Controlling the maturity of your bonds also allows you to get your money out of the market sooner. And because you get your principal back ($1,000 per bond), you have fresh cash to buy back into a rising rate market.
Maturities, when used properly, are the hidden bonus of bonds. They give the small investor the most important tool in money management – an exit strategy – and much more.