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Chapter 16 — The Trouble with Bonds
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The Trouble with Bonds

Although bonds can be very stable and dependable, they are not without risk. One major risk factor in bond investing is inflation. Inflation eats away the returns of long term bonds, and you must factor this in to find your real returns. For example, if you have a bond that is returning 5% and inflation is 3%, your real return is only 2% (5% bond interest rate - 3% inflation).

It is also important to be familiar with different provisions that are in place when purchasing bonds. For example, bonds can be issued with call options that allow the issuer to “call” back the investment and force you to sell the bond. Cases such as these cause some bonds to have a degree of unreliability even though they are issued with fixed interest rates and payment schedules.

The opportunity cost of purchasing bonds is more intangible but perhaps the biggest cost of all. The opportunity cost means that the investor cannot engage in more profitable opportunities that may arise if their capital is already invested in bonds. For example, when the stock market is having a strong bull run, the bond investor has no capital to take advantage because their money is locked into the bond market. Bonds also carry commission costs, which will be discussed in the next section.

Quiz

Bonds are being sold with an expected total return of 10%. Inflation over the same period is expected to be 8%. What is the actual return of the bond?

Correct
Incorrect
0/76 (0%) Correct
  • 1
    2%
  • 2
    12%
  • 3
    8%
  • 4
    -2%
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