My article last week “Look Out Below…For Bonds!” raised a lot of eyebrows and prompted a number of questions regarding what happens to bonds when rates do rise.
The bottom line is that rising rates are bad for bond holders. For example, let’s assume you have just purchased a 5% bond maturing in 5 years, at par (par is $1,000). At this moment, the bond is valued at its exact worth, not more or less.
For your purchase, you will receive annual interest of $50 ($1,000 x 5.0% = $50), until maturity when you will receive your principal back.
All the way up until maturity the value of your bond will fluctuate after your purchase as interest rates rise or fall.
So, what happens when rates rise? Let’s assume that interest rates rise to 7.0%. Because new bonds are now being issued with a 7.0% coupon, your bond, which has a 5.0% coupon, is not worth as much as it was when you bought it. Why you might ask?
If people invest the same $1,000 per bond that pays a higher interest rate, why would they pay $1,000 for your lower interest bond? Your bond would be less than $1,000 which is known in the market as trading at a discount.
On the other hand, if interest rates drop after your purchase, the value of your bond would go up because investors cannot buy a new issue bond with a coupon as high as yours. Therefore, your bond would be worth more than $1,000, known as trading at a premium. The bottom line is this…
If you hold it until maturity you will receive your principal back.
What happens to Bond Funds?
Plain and simple, bond fund investors get a double whammy. First, bond funds are perpetual, constantly buying and selling, rarely waiting until maturity. Therefore, there is never a “return of principal”.
Second, when interest rates rise, bond fund holders sell their shares. The fund manager at this point may be forced to sell bonds prematurely in order to raise enough cash to meet the fund’s redemption requests. This can be devastating to a bond fund and create additional risks. Redemption risk exaggerates the pain for those who remain in the fund.
Invest Tactically in both stocks and bonds!
My main concern is that with interest rates so low, who wants to lock in a bond which would just about guarantee a loss on your investment after inflation? Clearly no one. That’s why it is so important to manage your portfolio “Tactically”, never buy and hold. This is the only way you actively manage your assets to where the opportunities are for the future, not the past.
Read my latest special report: The 3 Styles of Money Management – Which is right for you?
Feel free to contact me with any comments or questions.