I’ve spent more time explaining bonds to clients than stocks, mostly overcoming eight great misconceptions about fixed income. I’ve found most advisors share those misconceptions. Here is how I explain bonds and correct those misconceptions.

What is a bond and why are they inversely correlated with interest rates?

Bonds are far simpler than stocks, alternatives, hedge funds, and derivative investments. A bond is a loan to either a corporation or a government and a bond fund is a collection of those loans. Say you lend a corporation $100 for 10 years at a 4% interest rate. You will receive $40 in interest and your $100 back. If, however, rates rise to 6%, you are getting $40 in interest while the market says $60 is the going rate. The value of the bond will decline. If rates fall to 2%, you are getting an extra $20 in interest over the market rate and the value of the bond will increase.

Far worse than interest rate risk is the chance of a default. If the issuer goes into bankruptcy, you will likely get no further interest and lose a good part of your principal.

Given that background, let’s look at the eight great misconceptions about bonds.