Many investors are unaware of the significant risk that seemingly “safe” bonds pose to their portfolios. I’ll try to make sure you’re not one of those investors.
When evaluating bonds, keep in mind that there are two primary types of risk. “Credit risk” deals with the issuer’s ability to make payments as they come due. I’ll discuss “interest-rate risk,” which concerns the risk posed by rising interest rates.
Some investors undoubtedly believe bonds are safe and can’t lose money, even if they don’t offer the upside potential of stocks. This mistaken belief hasn’t harmed them, as they reaped the benefits as the Federal Reserve embarked on its program of “quantitative easing,” pushing interest rates lower in order to stimulate the economy.
Fast forward to today, the economy is on firmer footing and investors are on pins and needles regarding when the Fed will start “tapering” its stimulus. We have no special insight, but have argued that with interest rates at historic lows and the economy strengthening, rates are more likely to move higher than continue on the downward trend.
To demonstrate the implications of a possible rising rate environment, it’s useful to take a step back to understand what a bond is and the inverse mathematical relationship between interest rates and bond prices.
A bond is a contract between a corporate or government borrower/issuer and the lender/buyer spelling out how much interest is to be paid (i.e. the “coupon”), when it will be paid, and when the borrower will repay the principal. Thus, bonds are often referred to as “fixed-income” investments.
While the timing and amount of payments are fixed by contract, the market value of that stream of payments will change as interest rates rise or fall.
Simply stated, the price of a bond is the current market value of the fixed stream of payments. If rates rise, the price of the bond falls because the fixed stream becomes less valuable. If rates fall, the price of the bond rises because the fixed stream becomes more valuable.
For example, the current benchmark 10-year U.S. Treasury bond (1.75 percent due May 15, 2023) was issued on May 8, 2013, at a price of 99.453420 (i.e. about $994.50 per $1,000 bond). For every $1,000 bond, the Treasury will pay annual interest of $17.50, half on Nov. 15 and half on May 15, and repay the principal of $1,000 when the bond “matures” on May 15, 2023.
Rates subsequently jumped, forcing the “yield” on this bond from 1.81 percent at issuance to 2.35 percent (price of $947.50) on June 19. Thus, investors who bought on May 8 lost the equivalent of about three years of interest payments in just over a month.
For historical perspective, the 10-year U.S. Treasury bond yielded nearly 16 percent in September 1981. In the ensuing 30-plus-year bull market for bonds, the yield plunged to 1.6 percent in September 2012.
I don’t think the yield on the 10-year Treasury is going back to 16 percent, but if the yield rises to the average for the past 10 years (3.5 percent), the price of the bond in our example will drop to about $854.50.
Does this sound like a “risk-free” proposition to you?•
Kim is the chief operating officer and chief complianceofficer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or firstname.lastname@example.org.