Taking inflation into account

An insidious, creeping threat to your bond portfolio is inflation.
Because bonds pay a fixed rate of interest, rising interest
rates and inflation can drive down your purchasing power.
If you have a well-diversified portfolio, your stocks and other
equity investments should rise in value to offset your losses from
inflation. Additionally, in 1997, the U.S. Treasury began to offer
inflation indexed notes, which I discuss later in this chapter in
the section titled “Visiting the U.S. Treasury Web site.”
Inflation and interest rates also determine how much a bond is
worth on the secondary market. The secondary market consists
of bonds sold after they’re originally issued but not yet matured.
If interest rates have risen since the bond was issued, the bond
is worth less and sells on the secondary market at a discount.
For example, a $1,000 bond paying interest at 5 percent
(called the coupon rate) when interest rates are 6 percent may
actually sell for $900 — a $100 discount.

If interest rates have gone down, the bond sells at a premium.
It’s worth more because it pays higher-than-market interest.
The yield for a bond is the return you actually receive on your
investment based on what you paid for it and the coupon
interest rate. Yield is calculated by dividing the amount of
annual interest by the bond purchase price. For example, if
you purchase an 8 percent bond for $1,000, your yield is 8
percent ($80 divided by $1,000). If you buy the bond for
$900, the yield is 8.89 percent. The higher the yield, the better
your investment.