Big losses in the stock market can send investors scurrying for “safe” investments.
But what is a “safe” investment?
Stocks are risky because stock prices go up and down all the time—sometimes wildly so—and if you have money invested in stocks, the value of your original investment can drop substantially.
In contrast, many investors put money in bonds to receive interest income and assume their original investment—their principal—will not change in value.
However, this assumption is wrong! You can lose principal in a bond investment, and you can make money in a bond. This is true whether you hold them individually, or collectively in the form of a bond mutual fund.
Bond prices go up and down for a number of reasons, but the biggest single factor is changes in interest rates. All bonds are affected by interest rate changes, regardless of the issuer or the credit rating or whether the bond is “insured” or “guaranteed.” And interest rates do change quite frequently.
Why do interest rates have such a big impact?
Let’s say your bond fund owns a 30-year Treasury bond yielding 6%. But now interest rates are up to 8%. How can the fund sell their existing bond, with a coupon of 6%, when newly issued bonds of similar maturity have an 8% coupon?
The only thing the fund can do is mark down the bond. In this example, the 6% bond would have to be sold at about 77.4 cents on the dollar—a loss of 22.6%!
What can you do to protect your money against interest rate fluctuations?
Interest rate changes have the biggest impact on long-term bonds, and a lower impact on short-term bonds. Think of a see-saw, with shorter-maturity bonds close to the center, and long-term bonds at the end: When interest rates push the see-saw up or down, there is less movement closer to the center, but the end is flung up and down much more dramatically.
If you want to play it safe, your best protection is to buy bond funds with maturities that are either short (under one year) or intermediate (between two and seven years).
|Table 1. Interest Rate Risk: Price Changes for 6% Bond If Interest Rates Rise|
|Maturity||Change in Bond Price If Interest Rates Rise To:|
This article appeared in the November 2001 issue of the AAII Journal.