3 Prevailing Myths About Bonds You Shouldn't Believe

With bonds at all-time lows and interest rates constantly in the media, there's a lot of misinformation going around. We asked our Motley Fool experts to separate facts from myths in the bond world. Here's what they had to say.

Dan CaplingerOne big myth accepted bymany people is that you can never lose money owning a bond or a bond fund. That myth comes from the idea that bonds are less risky than stocks and are thus a safe haven for those who don't want the risk of the stock market.

Yet bonds have their own risks. Interest rate movements change the value of bonds, and bonds with a long time horizon to maturity can experiencebig price swings even from small interest rate movements. Those fluctuations will affect how much you can get if you sell an individual bond before maturity. Bond funds can be even worse, as they typically don't have a set maturity date, so you might never earn back lost principal even if you hold the fund for years.

Moreover, when a business fails, bondholders often take a financial hit. In the final payouts, bondholders do have a spot in line ahead of shareholders, who are typically wiped out in bankruptcy and insolvency situations. But even some bond investors end up getting only pennies on the dollar, making it important for those who choose bonds other than government-backed Treasuries to look closely at the creditworthiness of the issuer before investing in its bonds.

One prevailing myth is that municipal bonds are completely tax-free and risk-free.

The one key benefit to municipal bonds is that their income is generally not subject to the federal income tax. However, income from municipal bonds might be taxable at the federal level under the alternative minimum tax. Furthermore, income from municipal bonds could still be taxed at the state and local levels depending on your state. Many states exempt resident stakeholders from taxation on that state's municipal bonds but still tax holders of out-of-state municipal bonds. In all cases, capital gains from selling a municipal bond or bond fund are taxable.

When it comes to risk, defaults are rare but not unheard-of for municipal bonds. Bondholders should note that municipal defaults have concentrated in the housing and healthcare sectors.

Source: Moody's.

As investment prospectuses everywhere read, past performance is no guarantee of future results. As many American cities' finances continue to worsen we will likely see more defaults similar to what happened with Detroit. If you aren't an expert, I recommend buying bond funds or exchange-traded funds, rather than individual bonds.

Index funds revolutionized stock investing by making it possible to buy hundreds of stocks yet pay only one inexpensive fee. When it comes to bonds, however, you may want to stick to actively managed funds.

In the world of index funds, weighting investments by their total stock-market value works fairly well. However, this approach doesn't work so well with bonds. While a stock index fund typically buys the most stock in the largest companies, bond index funds buy the debt of the most indebted companies. This is a particularly big problem in smaller corners of the bond market, such as junk debt ETFs or senior loan funds, which invest in some of the highest-yielding but riskiest bonds on the market.

Actively managed bond funds generally don't charge much more than a passive or indexed bond fund. Whereas the passiveiShares High Yield Corporate Bond ETF has an expense ratio of 0.5%, BlackRock's High Yield Bond Fund (BRHYX) recently reported a total expense ratio of 0.52%. The small difference is a price worth paying, particularly given that the actively managed fund has handily outperformed its benchmark.

The article 3 Prevailing Myths About Bonds You Shouldn't Believe originally appeared on Fool.com.

Dan Dzombak has no position in any stocks mentioned.He is a long-term investor and writes about happiness. Dan Caplinger has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright 1995 - 2015 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.