When you purchase a bond, you are lending money to an issuer that is usually a government, municipality, corporation, or federal agency. In return for that money, the issuer promises to pay a specified rate of interest periodically during the life of the bond and to repay the face value of the bond when it comes due. Bond maturities can be short term (0-5 years), medium term (5-12 years), or long term (greater than 12 years).
Interest paid by bonds can be fixed, floating or payable at maturity. For most bonds an interest rate is established when the bond is issued and fixed until maturity. The interest is a percentage of the face amount and generally paid semiannually. For example, a $1,000 bond with a six percent interest rate will yield $60 a year, in payments of $30 every six months. When the bond matures, say in ten years for a medium term bond, the full face amount of the bond, $1,000 is paid.
There are two primary risks to the investor holding bonds. The major risk is the possibility the issuer will default on the bond and not pay the face amount at maturity. The investor is somewhat compensated for this risk by higher interest rate payments for bonds issued by entities with lower credit ratings and thus more likely to fail. However even entities with excellent credit rating can fail during the period a bond is being held.
The other major risk is associated with the interest rate because over time the interest rate of new bonds being issued may be significantly greater than the bond being held by the investor. Let’s say you have a $1000 ten year bond paying 6% interest. Now suppose right after you purchased your bond the interest rate on new bonds went to 8%. What would your bond be worth? If the interest rate was unchanged the bond value would be $1000 the same price you paid. But if the rates were higher at 8% then the same yield of $60 per year could be obtained from a $750 bond so that would be the value of your bond paying 6% interest. If the interest rate increase occurred close to the bonds maturity then the face value of the bond would become more important than the yield.
Typical investors do not buy bonds directly, they purchase bond funds. Bond funds are professionally managed so the risk of a default of the principle is considerably reduced. But the interest rate risks are still present. As interest rates increase the value of each share of a bond fund decreases based on the considerations above. Share value may also be decreased based on where investors believe future interest rates will be.
Now consider the fact that bond interest rates have just started to rise off their 40-year minimums. Bond prices are started to decrease and the sentiment for higher rates and therefore additional losses is overwhelming. People wanting safe and secure future returns are turning to other fixed income-generating options.
Today’s option of choice is fixed index annuities, which are becoming the alternative to bonds. In just the week ended July 31, 2013 investors withdrew $6.94 billion from bond funds, marking the eighth week of net outflows in the last 9 weeks as investors pulled $4.07 billion from taxable bond funds and $2.87 billion from municipal bond funds. Fixed Indexed Annuity sales on the other hand have been increasing, totaling a record $33.9 billion last year.
Fixed Index Annuities offer the fixed income nature of bonds but are not affected by interest rate changes or subject to bond defaults.* They also offer gains related to equity market gains without being subject to equity market losses. A fixed Index Annuity is a recent addition to the annuity family that allows the annuity holder to have all of the benefits of traditional annuities while also sharing in stock market gains without being subject to loss of principle or accrued earnings due to stock market losses. This is accomplished by setting the annuity interest rate based on the stock market growth while still having a minimum positive interest rate if the market loses value. The insurance company passes a specified portion of the gain in a stock market index to the annuity holder in the form of interest on the accrued value of the policy.
Fixed Index Annuities offer other benefits to the holder. The most important being that the principle and accrued interest are 100% protected and guaranteed by the insurance company. Depending on how the annuities are structured they also can provide benefits beyond guaranteed periodic payouts including emergency funds when necessary, death benefits, nursing home benefits, and lifetime income benefits, meaning the holder will never outlive the income provided by the annuity. A further benefit is that the interest accrues tax free and is only taxed when withdrawn.
* Annuity product guarantees rely on the financial strength and claims-paying ability of the issuing insurer.
Annuity product guarantees rely on the financial strength and claims-paying ability of the issuing insurer.