Only 28 percent of Americans (Source: FINRA
) understand one of the most basic investment relationships: When interest rates increase, bond prices decrease, and when interest rates decrease, bond prices increase.
This lack of understanding leads many investors to think that bonds are a much less risky investment than they are. That could be a critical error for someone acting as their own portfolio manager.
Bonds and Interest Rates
Investors who purchase individual bonds and hold them until maturity need not worry about fluctuations in price. If the issuer is still solvent, the principal of the bond will be paid at maturity, no matter how much the bond fluctuated in value before maturity.
However, when bonds are sold before they mature, they trade in the secondary market
and the price is not the principal at maturity. The price depends upon prevailing interest rates, the bond coupon rate, time remaining to maturity and other factors. Interest rates constantly fluctuate so prices of existing bonds fluctuate. This is called “interest rate risk.” It is the risk that the value of bonds (or bond funds) will decline because interest rates increase.
Yields (interest payments divided by bond’s current value) and interest rates move in the opposite direction of bond prices. As bond prices increase, interest rates and yields decrease. As bond prices decrease, interest rates and yields increase. At maturity, the face value of the bond is returned to whoever owns it at that time.
Bond Purchasing Power Has Declined Over Time
Historically, the purchasing power of bonds has declined because of inflation and taxes.
The purchasing power of the interest from 1-year US Treasuries declined 96% from 1994 through 2020. There were two reasons: declining interest rates and increasing stamp prices.
Even if interest rates were the same as 1994, (5.3% instead of 0.36%), one-year US Treasury Bond interest would purchase 47% fewer stamps.
These declines occur because the dollar amount of annual interest paid and the price of the bond at maturity are fixed when a bond is issued. The payments are not adjusted for inflation.
Why Is This Important?
Many investors believe that bonds are a “safer” investment than stocks. Long-term investors need to know that there are many investment risks and bonds are risky in other ways, especially over longer periods of time.
- Bonds fluctuate in value less than stocks but as we saw in 2022, bonds can suffer significant declines when interest rates increase.
- Perhaps a more significant risk is loss of purchasing power because of taxes and inflation.
These risks are not a reason to exclude bonds from your portfolio. But they are reasons to carefully choose an allocation between stock funds and bond investments that meet your need for future, retirement income.
This presentation is for educational purposes only. To learn more about the topics mentioned and if they are suitable for you, consult an appropriate professional before implementing. Tax laws can change at any time.
Any information provided in this presentation has been prepared from sources believed to be reliable, but is not guaranteed and is not a complete summary or statement of all available data necessary for making an investment decision. Any information provided is for information purposes only and does not constitute a recommendation.
Keep in mind that:
- Past performance is no guarantee of future performance;
- Investments involve the risk of loss of principal and earnings;
- ETFs, mutual funds, including money market funds, etc. are not guaranteed in any way by the US Government, the FDIC, a bank or anyone else.
- “Average annual return” evens out variations in the actual year-to-year returns.
- ETFs, mutual funds and individual stocks and bonds fluctuate in value and there will always be times when they lose value.
- None of the information provided by Arthur Stein is necessarily relevant to anyone’s particular situation. Situations differ among individuals and you should not assume that these generalizations or information apply to you.
- Investments mentioned may not be suitable for all investors.
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