Last week’s column was a primer on Bonds. Now let’s take a closer look at how one can lose money owning bonds when interest rates rise. Aren’t bonds supposed to be safer than stocks?
First, what does the term “safe” mean? Most people equate financial risk or safety with stability of fair market value within short periods of time.
For example, Microsoft stock has risen from a split-adjusted price of about 9 cents a share in 1986 to a new temporary high of $95 on Monday, January 29. But the risk is that its price may fall by 14 percent or more in a short time. It did exactly that twice in the first six months of 2016. So people could consider it an unsafe investment.
Second, there is no absolutely safe investment existing in the entire world today. A certificate of deposit, or CD, of $250,000 has its principal guaranteed by the FDIC, an agency of the US government. But someday, our government will undoubtedly fail just like every other one in history. Money buried in the ground can be dug up by thieves.
But buying bonds—lending money to an organization–has usually experienced less price instability than owning stocks. Since October 1981, when the 30-year U.S. bond interest was 14.8 percent, bond yields have dropped in fits and starts to the current rate of about 2.94. (www.macrotrends.net)
Thus one could have lent the federal government $100,000 and collected $14,800 per year until October, 2011, a total of $444,000. Then you received your 100 grand back. It turned out that would have been a fantastic deal!
During those 30 years, as interest rates on newly issued 30-year bonds dropped, the holder could have sold his for a premium. Why? Because the new purchaser could not find the same 14.8 percent yield on any similar bond.
The same principle works in the opposite situation. Suppose you had bought that 30 year bond last Monday with the 2.94 yield. Now suppose inflation keeps rising and the Federal Reserve continues to raise its interest rates. That is its plan.
There is a confusing term for the price of a bond relative to the change of interest rates, duration. It is the estimated price change percentage that will be caused by a 1 percent change in interest rates. That number is about 20 for our 30-year bonds.
So if in 2019, a new 30-year U.S. bond is issued with a 3.94 yield, your existing bond will be worth only $80,000 if you want to sell it for any reason. This $20,000 loss of value might have occurred slowly, but it’s still real money on your personal balance sheet. It is even a greater loss than the temporary 14-15 percent fall in the price of Microsoft cited above.
The other fact you should know? The longer the bond maturity, the greater this effect. So in this current climate, the shortest term bonds will suffer the least as interest rates rise.
Why does this matter? Often investors make investments at exactly the wrong time. The Investment Company Institute reports weekly flows of money in and out of all mutual funds. Investors are still adding millions of dollars each week to both taxable and muni bond funds. As interest rates rise, we shall see if they remain happy with their falling account values.
(Past performance is no guarantee of future results. Advice is intended to be general in nature. Microsoft statistics from Worden Brothers, Inc., TC2000, 2018.)