Nobody really knows how the economy will behave in the future, but it doesn't take a financial wunderkind to know that when unemployment is high, stocks prices are dropping and consumer prices are rising, times are tough. Even during times when the economy sours, you still want to your investments to perform well. That could mean shifting some of your money into bonds, but even with ultra-safe U.S. government bonds, you risk losing buying power.
When you invest in stocks, you are buying a piece of the company. If the economy heads south and the company goes under, your investment goes under with it. When you buy bonds, you are loaning money to the issuer, which could be a company, a municipality or the federal government. Bonds have traditionally been categorized as safer than stocks, in part because if you hold them to maturity, you get your original investment back plus interest. But if the issuer goes bankrupt, you could still take a loss.
Interest Rate Risk
One of the big risks of investing in bonds is a change in prevailing interest rates. This is of particular concern when current interest rates are low, because the market price of bonds tends to move in the opposite direction of prevailing rates. If interest rates for new issue bonds rise, the market value of existing bonds declines. That won't make any difference if you can hold onto your bonds until they mature, but if you have to sell them early, you might get less than face value.
Supply and Demand
When the economy sours, investors tend to move out of stocks and into bonds. In most free market situations, when demand exceeds supply, prices tends to rise. But when it comes to bonds, increased demand tends to cause the initial interest rate to decline. The result is you might get a safer investment for your principal, but you have to accept a lower rate of return on your money.
Short-Term vs. Long-Term
No one knows how long a sour economy will last. That's one reason to keep your bond investments short-term during such times. Short-term bonds typically offer a lower interest rate than long-term bonds, but you're not locked in for an extended period of time. If the economy turns, the shorter maturity dates give you access to your funds sooner, so you can take advantage of a rising market.
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