We’re all aware that stocks go up and down, but it’s less obvious that the same can happen to bonds, even when the credit standing behind the bond is rock solid.
Material on this page is adapted from our book, That Thing Rich People Do: Required Reading for Investors.
Companies and governments issue bonds when they borrow money. The bond represents the right to receive repayment of the loan with interest. If you buy a bond directly from the company or government that issued it, you’re making a loan to that entity. More often you’re buying the bond from a previous owner, and when this happens you take over the right to receive future payments on the bond.
Suppose you bought a $1,000 bond paying interest at 4%. It was issued by the U.S. government, so there’s not the slightest doubt that the payments will be made. The holder will receive $40 per year until the bond matures, when the final interest payment will be accompanied by repayment of the original $1,000. You can keep this bond and receive these payments, or you can sell it to someone else. Similar bonds are trading for about $1,000, so you would break even on a sale.
Now suppose that shortly after you bought the bond interest rates rose so that similar bonds that are newly issued by the U.S. government pay interest at 6%. Your bond isn’t directly affected: you’ll continue to receive interest at 4%. If you check the market value of your bond, however, you’ll find that it’s now less than $1,000. The reason is that no one in their right mind will pay $1,000 for a bond paying 4% interest when they can spend the same amount of money to get a bond paying 6% interest. Your investment has lost value.
If you’re like most people, you hold your bond investments through one or more mutual funds. Your mutual fund shares will go up and down in value as interest rates change, and the price you get when you sell will be based on the market value of the bond portfolio held in the fund at that time. If that value is lower than when you bought, you’ll suffer a capital loss. You lose money on the sale even if all the bonds held by the fund are issued by, or guaranteed by, the U.S. government.
It might seem that you can avoid a loss by holding bonds directly instead of buying shares of a bond fund. In this case you can continue to hold a bond until it matures. You’ll receive all the money you paid for the bond plus the interest payments. Yet the interest payments you receive throughout that period will be smaller than if you could invest at today’s higher interest rate. The cost of that lost opportunity is precisely equal to the decline in the market value of your bond. Continuing to hold this bond is just a different way of absorbing the loss.
The key thing to remember: an increase in interest rates may be good for someone who’s about to buy bonds, but for someone who already owns bonds (directly or through a mutual fund) higher interest rates mean lower values.