Investing in Your 20s and 30s: Bond Returns - dummies

By Eric Tyson

When you purchase a bond, you should earn a higher yield than you can with a money market or savings account. You’re taking more risk because some bond issuers (such as corporations) aren’t always able to fully pay back all that they borrow.

By investing in a bond (at least when it’s originally issued), you’re effectively lending your money to the issuer of that bond (borrower), which is generally the federal government or a corporation, for a specific period of time. Companies can and do go bankrupt, in which case you may lose some or all of your investment. Government debt can go into default as well. You should get paid in the form of a higher yield for taking on more risk when you buy bonds that have a lower credit rating.

Jeremy Siegel, who is a professor of finance at the Wharton School at the University of Pennsylvania, has tracked the performance of bonds (and stocks) for more than two centuries! His research has found that bond investors generally earn about 4 to 5 percent per year on average.

Returns, of course, fluctuate from year to year and are influenced by inflation (increases in the cost of living). Generally speaking, increases in the rate of inflation, especially when those increases weren’t expected, erode bond returns.

Consider a government bond that was issued at an interest rate of 4 percent when inflation was running at just 2 percent. Thus, an investor in that bond was able to enjoy a 2 percent return after inflation, or what’s known as the real return — real meaning after inflation is subtracted. Now, if inflation jumps to, say, 6 percent per year, why would folks want to buy your crummy 4 percent bond? They wouldn’t, unless the price drops enough to raise the effective yield higher.

Longer-term bonds generally yield more than shorter-term bonds, because they’re considered to be riskier due to the longer period until they pay back their principal. What are the risks of holding a bond for more years? There’s more time for the credit quality of the bond to deteriorate (and for the bond to default), and there’s also more time for inflation to come back and erode the purchasing power of the bond.