Rising rates not good news to bondholders

Most experts believe that interest rates will be rising in the near future (of course, they thought so two years ago, too). Soon it may cost more to borrow money, and you may get a little extra on your income investments. But your bonds may lose value.

Blame the inverse relationship between bond prices and yields. If interest rates rise, the prices of existing bonds drop. Why? Well, let’s say you have a bond that yields 5 percent. Then rates rise, and a new bond comes along yielding 5.25 percent. If you want to sell your now-less-attractive bond, you’ll have to offer a discount to compensate for the lower yield.

This is not a big deal for those who invest in individual bonds. As long as you hold the bonds until maturity, the issuer will return your entire principal (assuming the issuer is still in business).

However, if you invest in bond mutual funds, you may be in for a surprise. In 1994 and 1999, for example, a series of rate increases resulted in losing years for the average bond fund. With interest rates still near historic lows, it would seem that rates have nowhere to go but up.

To be sure, bond funds do have advantages. They (1) offer diversification, (2) make the investment of small amounts — including the reinvestment of dividends — a snap, and (3) offer the potential for capital appreciation. Many bond funds returned more than 20 percent in 1995. And despite three rate increases in 2000, some bond funds posted double-digit returns for the year.

If you’re truly after principal preservation, though, here are some considerations:

“ If you have the resources and know-how, invest in individual bonds. It’s especially easy to invest in Treasury securities, including the popular inflation-indexed I Bond. Visit www.treasurydirect.gov to buy, commission-free. (Another good site is www.bondsonline.com.)

“ Consider short- or intermediate-term bonds or bond funds. Long-term bonds are more volatile, and the extra yield you’d get may not be worth the risk.

“ Check out bond alternatives for your short-term savings. We offer some guidance at www.Fool.com/60second/savings.htm.

Learn more about mutual funds at www.fool.com/mutualfunds/mutualfunds.htm.

Ask the Fool

Q: Is there any way for me to buy odd lots (say, 10 or 25 shares) of various stocks? Do I need to buy 100 shares at a time? – O.G., Binghamton, N.Y.

A: Most brokerages don’t restrict how many shares of stock you can buy. You can buy three, 92 or 17,566 shares. But pay attention to what percentage of your investment is going to commissions.

If you’re spending $250 on 10 shares of a $25 stock but are paying a $15 commission to your broker, that represents 6 percent of your investment, which is too costly (15 divided by 250 is 0.06, or 6 percent). Aim to pay no more than 2 percent in commissions.

Learn more about brokerages and how to select a good one at www.broker.fool.com and at www.investopedia.com/university/ broker/broker4.asp.

Q: What percentage gain should I shoot for in a stock? – M.P., Hartsville, S.C.

A: Don’t necessarily think in terms of percentages. Instead, if you’re thinking of selling after a certain percentage gain, consider whether the company is still executing well. Many people bail out after a certain gain, perhaps 10 percent or 30 percent. But it’s often more profitable to hang on to the stock for years or decades, as long as you retain faith in it. Many people who’ve made fortunes in stock have done so by hanging on for many years, even after their shares doubled and later tripled in value.

My dumbest investment

On a tip from a friend, I bought 900 shares of a little-known biotech company, which had a test for AIDS detection. I got in at $11 a share. Over time, the shares went south. Company reports said they had a “challenging” year, but expected a turnaround “in the near future.” I could have gotten out at $10, $8, etc., but I didn’t. Finally, I sold at $1.50 per share, losing my shirt. Was it wishful thinking or compulsivity that stopped me from cutting my losses? I don’t know. Do you? – John Cavanagh, Morgantown, Pa.

The Fool responds: First off, if you bought on the hot tip without doing any research, you probably knew very little about the company. That can make it especially hard to make decisions about when to sell. Psychology plays a big part in investing. Wishful thinking is one danger, especially when you don’t know much about the company. Learn as much as you can about any company you invest in — by reading its annual and quarterly reports.