I recently met with several new clients who asked for my help after the bonds or bond funds they had purchased in the last few years had lost value. The question they asked is “why.” I will explain in this article why bonds can lose value.
First of all, bonds offer two very important guarantees. The first guarantee is that the interest rate will remain constant. The second guarantee is that at some point in the future called a “maturity date,” the investor will get their money back. Prior to the maturity date, however, all bets are off and the value of the bond may fluctuate (and most likely will), depending on a variety of factors.
One of the most influential factors that cause this fluctuation is the current interest rate environment. Most investors know that the value of a bond has an inverse relationship to the current interest rates but most folks don’t understand why it works that way. In short, when interest rates rise, the value of a bond declines and when rates decline, the value of a bond rises.
To illustrate, let’s say an investor has purchased a ten-year bond for par ($1,000) with an interest rate of 6% and they have owned the bond for five years, receiving interest during that time. Now they need access to their principal, but since the bond hasn’t matured, the only way for them to get the principal is to sell the bond through a broker to whoever is willing to buy it.
But let’s suppose that the current interest rate for a five-year bond with similar characteristics has gone up to 8% over the last five years. Therefore, an investor can buy a five-year bond today for par value and currently get 8% annual interest.
The question is, why would an investor pay $1,000 for your bond that is only paying 6% interest when they can buy an equivalent bond for $1,000 that is paying 8% interest? Of course, they wouldn’t.
Therefore, the only way to sell the bond with 6% interest is for the current owner to offer it at enough of a discount so that the new purchaser will still receive an 8% return (yield) on the bond. This is referred to as discounting the bond, or selling the bond at a discount. In our example, the current owner would have to sell the bond for $920 for the buyer to get an 8% return if they held it to maturity. This would represent a loss of about $80 per bond or 8%! Imagine if you owned $100,000 of these bonds because you thought they were safe!
In addition to the interest rate environment, there is another factor which causes bonds to fluctuate in value: good ol’ supply and demand. The reason some bond values are down lately is because the stock market has done so well. Who wants to buy a bond with 5% interest when they can buy a stock that may go up 50% or more in the next six months (as has happened in the last six months)? In other words, the demand is low. Therefore, if you want to get rid of your bond, you may have to make it more attractive by lowering your asking price and taking a loss.
Logically, if interest rates are such an integral part of a bond’s value, doesn’t it make sense to know what the interest rate environment is when purchasing a bond? Where are interest rates today? High or just about the lowest they’ve ever been? Interest rates are extremely low, which is why the federal government recently completed a bond offering at 0% interest! Therefore, where are interest rates likely to go in the next decade or so? Up, since they can’t drop any further than 0%! If this proves true, bond values will ultimately decline in value.
What about bond funds? The short answer is that this is the wrong environment for them. Bond funds force you to give up the two most important certainties offered by bonds because they don’t offer a guaranteed interest rate and they don’t ever mature. If you have a bond and it drops in value, you can wait until it matures and get back your investment, effectively negating the paper loss. With a bond fund though, the paper loss could potentially turn into a permanent loss since there is no maturity.
In conclusion, my belief is that in today’s environment, an investor should only buy bonds that they can hold to maturity. And, if you must own bond funds, make sure the individual bonds inside the fund have a short duration.