When long-term bonds don’t keep up the pace
The relationship between bonds and interest rates is an important one. Investors should understand how they interact with each other when considering bonds as an investment.
Bonds are just IOUs. Put simply, you give someone money and they give you a promissory note.
Although many names are given to debt instruments — bonds, mortgages, notes, Treasuries — to simplify the concept just know they are all debt in one form or another.
The interest or “usury” rate is what the borrower pays you to use your money. The longer you loan out your money, the higher the rate usually is to compensate the lender for having to wait that much longer before having his money returned and for the risk of not getting it back at all by some sort of default.
Bonds and interest rates move opposite of each other in the open market and it’s this contrary movement which can confuse investors.
Think of it this way. Suppose you buy a 10-year bond with a 3-percent annual interest rate for $10,000.
If you hold the bond until the end of its 10-year term, you get your money back with 3 percent on top of that for every year you wait.
This equates to $300 a year in interest for 10 years or $3,000 (for simplicity we did not compound the interest).
Now imagine interest rates spike to 4 percent the day after you bought your 3-percent bond.
Now suppose you need to sell your 10-year bond early due to an emergency. Why would anyone buy your bond paying 3 percent when today’s rate is now 4 percent?
The answer is they wouldn’t. But the bond markets are liquid, meaning they want you to be able to get out of any public bond if the need arises.
How they price your bond to sell, even though it’s paying less then the going interest rate, is the secret to understanding how bonds work.
What happens is the markets takes the difference a 4-percent bond would pay over 10 years ($10,000 x 4 percent = $400 x 10 years = $4,000) and compare that to the interest your 3-percent bond would pay ($10,000 x 3 percent x 10 years = $3,000).
The 4-percent bond would pay $1,000 more than your 3-percent bond would over 10 years so they subtract that $1,000 from the sell price.
Your bond is now “discounted” to reflect the lower interest rate it has when compared to the more favorable current rate.
The result is you now get $9,000 for what once was a $10,000 bond. You lost $1,000 or 10 percent due to the spike in interest rates.
This interest rate risk to bond investors is real; the longer term the bond is the more pronounced the risk.
Bond funds will reflect interest rates on a daily basis while individual bonds will only surprise investors when they go to sell them early.
You could keep the bond until maturity and get the full amount back, but the worry there is that higher interest rates mean higher inflation. Every year you are stuck in a bond is one more year your money is not keeping up with the rising prices around you.
This article expresses the opinions of Marc Cuniberti. Cuniberti hosts “Money Matters” on KVMR FM 89.5 and 105.1 FM at noon Thursdays. He has been featured on NBC and ABC television and on a host of made for TV documentaries for his economic insights. His website is http://www.moneymanagementradio.com.
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The MEME stocks are on fire again. You remember these. My last article on the MEMEs was the called “The Game that is Gamestop.”