If you plan on investing money in bond funds for 2014, 2015 and beyond, you ought to know how you actually make money investing in these popular funds. If you are an average or new investor you should also know how you can lose money.

As a financial planner I found that my clients (mostly average or new investors) generally liked their bond funds, but few really understood how you make money investing in them. They probably liked them because these funds seemed to consistently make money year after year. On the other hand, many of my clients preferred to avoid stocks believing them to be too risky.

Let’s get down to basics. You make money in bond funds in two basic ways: dividends and rising share prices. These dividends come from interest earned in the fund’s portfolio which consists of long term debt obligations called bonds. A debt obligation is simply an IOU. Example: I owe you $1000 due in the year 2034… and will pay you interest at a rate of 4% a year until I pay you back. These obligations are issued by government entities (like the U.S. Treasury) and by corporations to raise money.

When you put money into bond funds (like $10,000) this buys you shares, and the number of shares you get is based on the share price at the time your purchase order goes through. You are then paid dividends periodically based on the number of shares held. These dividends can be sent to you, but most average or new investors simply tell the fund company to reinvest them to buy additional shares (at the prevailing share price). Most investors understand that you make money investing in bond funds by receiving interest income in the form of dividends.

The main appeal to investors is that these funds pay higher interest income then bank savings accounts, money market accounts and CDs, which are presently paying way less than 1% for 2014, 2015 and beyond. For about 30 years average and new investors have been happy with bond funds because they could make money even when interest rates got ridiculously low.

The question that rarely crosses the mind of average and new investors is: how have these funds produced such good returns in the past few years when interest rates have been so low (in fact at historical lows). This takes us to the second way you make money investing in bond funds: rising share prices.

When interest rates are falling, like they have been for most of 30 years, the share price (value) goes UP. The total value of your fund account is: number of shares times the value per share. First, most investors reinvest their dividends to buy additional shares, so part of the increase in their account’s value is due to owning more and more shares over time. The real reason they’ve been able to make money investing in this low interest rate economy is that their share price has been going up.

Investing 101: when interest rates fall, bond prices (values) go UP; when rates rise they go DOWN… and investors lose money. Think of the $1000 IOU that paid 4% ($40 per year) we discussed earlier. Now, picture that this IOU trades in the market and can be bought and sold on any business day as it fluctuates in price, as stocks do. What would you (or investors in the market) pay for this IOU if new comparable issues were available in a few years that paid 8% or more?

Now, picture that you own a very small part of a large portfolio holding this IOU and many more like it. Welcome to the world of investing in bond funds when interest rates go up. When interest rates went up and peaked in 1981 some investors in bond funds had losses of 50%. If rates for long term bonds go from about 4% to 8% or more, a 50% loss is again possible. After all, if a new $1000 IOU pays interest income of $80 per year, a similar IOU paying only $40 per year is worth about half as much. You’d need to own two of them to get the same interest income.

There are two ways to make money investing in bond funds, but in 2014, 2015 and beyond you can make money or lose money. Average and new investors need to be aware of this reality. People like to be optimistic and many investors just want to hear how easy it is to make money investing. I write to inform, and firmly believe in telling the rest of the story.

Source by James Leitz