Bonds have long been the backbone of the safer, or more conservative, portion of an investment portfolio, and bond-owning mutual funds have been stellar performers this year.
But now bonds are looking riskier. Interest rates are so low that they’re more likely to go up than down, and that could undermine bond prices.
There is a way to minimize this risk: Buy individual bonds rather than bond funds, and plan to hold them to maturity.
Bonds are loans from the bond buyer to the bond’s issuer, such as a government agency or corporation. Buying a 10-year bond with a $10,000 face value and 4% yield means you are lending that amount to the issuer. For the next decade, you will receive $400 a year in interest, and then the issuer will return your $10,000 “principal.”
But if you want to sell the bond before the 10 years are up, its price will be determined by supply and demand in the market, and that’s largely governed by changes in prevailing interest rates. Rising rates drive bond values down, falling ones push them up.
Just imagine that new bonds paid 8%, so that an investor paying $10,000 would earn $800 a year, twice what your older bond pays. Your bond’s price would fall to $5,000, because that’s the point where its $400 payment would match the prevailing rate of 8% of the invested sum.
In real life, other factors like the bond’s time to maturity and the issuer’s potential for default make the price calculation much more complicated. But it’s not uncommon for a one percentage point rise in rates to drive a bond’s price down by 5% to 10%.