Since the start of the year, the Bloomberg US Aggregate Bond Index has lost nearly 9% of its value, which may surprise you if you don’t realize that bonds can lose money. Today I would like to explain how bonds can lose value when interest rates rise.
As a reminder, bonds are simply loans from a lender to a borrower. Unlike your mortgage where you are the borrower, owning bonds means that you are usually the lender to businesses or government entities that will eventually repay you the original loan amount plus interest. Much like a mortgage, there is an interest rate charged to the borrower as well as a specific term over which payments will be made. A key difference is usually that the principal amount is not repaid until the end of the loan rather than along the way. Until maturity, you simply receive interest payments.
As interest rates fluctuate, the value of the bond you own changes inversely to interest rates, as there is an active market of buyers and sellers who are constantly reassessing the value of your bonds. depending on various factors. The most relevant factor for today’s article is the current interest rate versus the original interest rate on your bond.
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A simple example is the best way to understand this relationship. Imagine that you own a bond paying one percent interest that you bought two years ago for $100. Fast forward to today and new bonds maturing at the same time as your original bond are paying 2.5% interest and selling for $100 each. If you wanted to sell your 1% bond, you would need to sell it for less than $100 to make it attractive to potential buyers. You might be able to sell it for $97 to make it competitive with a new bond. The drop in price represents interest rate risk and would be an actual loss if you sold the bond.
This interest rate risk applies not only to individual bonds, but also to bond mutual funds made up of a basket of individual bonds. Bond funds have a higher turnover of their underlying bonds, so the proceeds from maturing bonds can be reinvested in new bonds at higher rates, helping to offset some of the price declines.
In addition to understanding how rising interest rates affect the value of your bonds, which increases the likelihood of sticking with your investment strategy, there are a few other strategies you can consider such as holding bonds at shorter term that are less sensitive to interest rates. As rates rise, bank CDs or fixed annuities may also become more attractive. My colleague, Mike Haubrich, wrote in April about Series I Savings Bonds, which are also worth considering. Nobody likes to lose money on their investments, but understanding why it happens can lessen the psychological impact.
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Justus Morgan is president and fee-based financial planner at Financial Service Group Inc., an investment advisory firm registered at 4812 Northwestern Ave., online at ToYourWealth.com.