The Ups and Downs of Bonds and Interest Rates

Arthur Stein Financial, LLC |
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 volatile investment than they are. That could be a critical error for someone acting as their own portfolio manager.
 
The Securities and Exchange Commission (SEC) was concerned enough about this that it issued a bulletin titled When Interest Rates Go Up, Prices of Fixed-Rate Bonds Fall.
 
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.
 
Many investors prefer to buy bonds through mutual funds, Exchange Traded Funds (ETFs) or other investment vehicles. The price of those funds also fluctuates daily as interest rates change.
 
Purchasing Power
Another problem with bonds is loss of purchasing power. Since interest and principal payments do not increase over time, inflation reduces the purchasing power of those payments. What’s more, federal taxes on interest income are higher than on stock dividends and capital gains.
 
As an example of loss of purchasing power, look at how many first-class stamps could be purchased with the interest from a one-year U.S. Treasury bond purchased at the beginning of each calendar year.
 
 
Over this 19-year period, the number of stamps declined from 183 to four -- a drop of 78 percent in purchasing power!
 
Why Is This Important?
 
Many believe that bonds are a more “conservative” investment than stocks. Using the term “conservative” makes them sound safer. But it is more accurate to say that bonds are less volatile than stocks. Bonds fluctuate in value less than stocks.
 
At a time of relatively low interest rates, bonds become a riskier investment. Why? Interest rates are more likely to increase than decrease over time. If interest rates increase, the value of existing bonds (and bond mutual funds and ETFs) will decrease. The so-called safe investment falls in value.
 
At present, interest rate risk is high because of low interest rates. A New York Times article quotes Lori Schock, director of the SEC Office of Investor Education and Advocacy: “We’re not predicting what’s going to happen to interest rates or when . . . but we do know that rates can’t go much lower. And we know that they can go a lot higher.”
 
Here is a recent example. Interest rates increased between May 2 and July 5, 2013. The 10-year Treasury yield increased from 1.63% to 2.72%. According the Wall Street Journal, this is the resulting change in the value of different categories of bond mutual funds.
 
 
Interest rate risk is not a reason to exclude bonds from your portfolio. But it is a reason to ensure that the allocation of your investments takes into account the current historically low interest rates. 
 
Short- and medium-term bonds will hold up better if interest rates increase. If interest rates increase substantially, that could be a good time to shift to longer-term bonds.
 
Notes:
 
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;
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  • “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.
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