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You CAN Lose With Bonds

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:
7.0% 8.0% 9.0%
1 Year –0.9% –1.8% –2.8%
5 Years –4.1% –8.1% –11.8%
10 Years –7.5% –13.5% –19.5%
30 Years –12.4% –22.6% –30.9%

This article appeared in the November 2001 issue of the AAII Journal.

 

6 thoughts on “You CAN Lose With Bonds”

  1. Important missing fact: the other way to “play it safe” is to hold the bond to maturity. If you do that, the full value of the bond will be returned (unless the bond issuer defaults)…

     
    1. John,
      You are fooling yourself if you think you escape the loss. The loss results in the amount of interest you will collect on the bond until maturity. It will be less than the market rate, so you incur a loss with every interest payment.

       
    2. John is absolutely correct. When you buy an individual bond, you control when to sell the bond or to hold it to maturity. The problem I see with a bond mutual fund is that when other individual investors in your fund panic and withdraw money from the mutual fund, the fund manager must sell bonds in the fund (at a loss) to generate cash to pay the withdrawals; hence the value of the entire mutual fund goes down by default. You can choose to hold your individual bonds until maturity, collect the interest, and get the full principle back in the end. A closed end bond mutual fund should work the same way as individual bonds and would provide diversification.

       
  2. John,

    In most cases holding the bond fund to its “duration” will return the yield that you paid for when you bought it, or more if you reinvest the dividends.

    What I think the author failed to mention is that if you sell the 6% bond for a “loss” and buy the current going rate 8% bond you will essentially (less transaction costs) get the same return as if you had held the 6% bond to maturity. That’s the way bonds are priced.

    The authors point about buying shorter duration bonds is the key. If you buy a 30 year bond @ 3% I don’t think you will think you “played it safe” if a year later 30 years bonds are selling for 6%. You will most likely be losing money to inflation along the way.

     
  3. Even if one’s bond interest rate is greater than the rate of inflation and at maturity he gets his principal back, a long-term bond investor will lose. That is because the purchasing power of the principal will have diminished during the holding period.

     

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