Ever since the housing bubble burst and the stock market crashed, investors have been fleeing equities and either keeping their money in cash, or investing it in bonds. This is done for safety. With cash, one cannot lose principal, unlike with equities. I fear though that many investors misunderstand bonds as being like cash in that it is hard to lose the principal. While being more conservative than equities, one can still lose money when investing in bonds. My fear is that too many investors think that conservative means not losing money when that is not the case.
How Bonds Work
The historically low interest rates have propped up bond prices along with investors pouring money into bonds. To understand why this is a problem, we need to understand how bonds work: there is an inverse relationship between a bond’s price and its yield (interest rate). Assume a bond is yielding 4%. If the market demands a higher yield, say 6%, then the price of that bond will decline as investors flee the bond paying 4% and invest in the bond paying 6%.
When interest rates begin to rise, many investors are going to demand higher yielding bonds. In many cases, the yields offered by bonds will not be enough and investors will flee to the stock market to invest in equities. As a result of demanding higher yields, bond prices will drop. With the additional lack of demand for bonds from those fleeing to the stock market, prices will decline even further.
The people that will get hurt the most from this will be those in retirement as well as those on the cusp of retirement. These investors will not be in a position to take on the additional risk of the stock market and will need to remain invested in bonds. They will be the casualty from the fall in bond prices.
You may be thinking that even if bond prices drop, won’t the increase in yield offset the loss? Unfortunately, it won’t. In most cases, the price drop of the bonds will be much more than the increase in the interest rate. For a bond yield that goes from 4% to 6%, the price drop will be close to 10%. The further the bond is from maturity (longer term bonds), the greater the drop in price will be.
So what are investor’s options? The best defense is to invest more in shorter term bonds. These bonds are less prone to volatile swings in prices due to a changing interest rate environment. Also, you may want to consider money market funds and laddering a portfolio of CD’s. Both of these will allow you to take advantage of rising interest rates while keeping your principal safe. Of course, the Federal Reserve has said it plans to keep interest rates artificially low through 2013. When interest rates rise is anyone’s guess, but if you are invested in bonds thinking you can’t lose money, think again.