Investing in bonds should be one of the simplest form of investing.  I lend a government, corporation, or other entity money and it agrees to pay me that money back at an agreed upon interest rate.  So long as they don’t default on the loan, I will get that return on your investment.  For individually issued bonds held to their maturity, that’s pretty much the deal.  However most people invest in bonds via mutual funds or ETFs and that makes things a little more complicated.  If you read any article on bond investing, it will inevitably state that the yield of a bond fund (interest it pays you) moves inversely to its price.  That might not make sense, if the bond is now yielding more, shouldn’t it be more valuable?  Sort of.  I always find it is easiest to explain with an example.

Remember a bond is just a loan.  Let’s say you lend $10,000 to Bill, at a 10 year fixed rate of 3%.  Bill has a history of paying his debts in the past and therefore you have confidence he will pay you back.  Let’s say next year Bill is looking for another 10 year loan, but circumstances have changed.  Maybe Bill is starting to struggle with his bills (ha!) or the interest rate environment has changed and now the best rate he can get is 5%.  Now, let’s say you don’t really want the original 3% loan you made to Bill and are looking to sell it to someone else.  Do you think someone will pay you $10k for it?  Why should they?  Your loan to Bill only pays 3%, you locked in that rate when you made the original loan, but they can issue a new loan to Bill at 5%!  The only way you can sell your loan to another investor is if you drop the price. The amount you drop the price of the bond is to make up for the lost revenue that the person would get between your 3% loan and the 5% loan they could make to Bill.  The same happens in reverse if current interest rates drop, your loan to Bill suddenly looks even more valuable and you can raise the price.  How much depends on the difference in interest rates and how much longer you have the loan.  In other words, if you want someone to be saddled with this 3% loan for 10 years, you’re going to have to drop your price more than if it were only a year.   This is why interest rates impact the prices of long term bond funds a bunch, and short term bond funds not as much.  You might even need to drop the price so much you lose money on the investment, even though Bill hasn’t defaulted!  That is not smart investing.

This is another example of why it pays to be long term on investments.  You don’t have to sell the bond.  You can keep it, be happy with the 3% you’re getting, and as long as Bill doesn’t default, you’ll get all your money back, with the interest you agreed upon.  Buying a little bit over time is a good way to even out the ups and downs of the bond markets just like with stocks.  It is important to understand that you aren’t buying bonds for these ups and downs in price.  A bond is a loan, you are buying it for its yield,    This is critical when evaluating loans as investments.  This can be illustrated looking a curve of the 10 year US treasury (10 year loans made to the US Government) and the return of the Vanguard Total Bond Market ETF (BND) 

The BND return is generally higher because it has some higher yielding bonds in it, but there is a critical conclusion here. As the 10 year US treasury bond yield, and interest rates in general, have declined over the past 35 years, bond fund returns have fluctuated wildly, but the average return pretty well tracks this yield. It has to, the yield of the bonds is what is making you money! The drop in interest rates has been great for home buyers because of lower mortgage rates, great for businesses borrowing money to expand, but a hit to anyone looking to make money by lending it to others. Looking at the chart above, seems clear that you should not expect average bond returns to be more than a couple percent, maybe even lower for the next few years.