FAQ: Why do bonds, which are supposed to be safe, fluctuate in value?
Answer: Certainly, this is a question that is often asked by those in retirement trying to protect what they have. Let’s discuss this in two ways, individual bonds and bond funds. Although both are essentially bonds, they have slightly different risk characteristics that it is important to understand when investing in bonds.
Let’s start with a simple explanation of what a bond is and how it works. When you purchase a bond, you are lending money to some entity (the government, a public or private company, etc.). In exchange for lending this money, the borrower will pay you interest, typically, each year that the money is lent. At the end of the period, you will receive your last interest payment as well as the principal returned to you.
As an example, if I were to purchase a 10-year treasury bond from the Federal Government for $10,000 at a 1% interest rate, I would receive $100 per year and at the end of year ten, my $10,000 would be returned. There are lots of different types of bonds that can have various features, such as converting to stock at some point in the future (convertible bonds), don’t pay any interest until the end of the term (zero coupon bonds), or any number of variations of interest payment, length of time, and return of principle. For the sake of simplicity in our explanation here, I will limit the scope of our discussion to the 10-year Treasury bond.
Single Bond: In the above example, if I purchase a 10-year treasury bond from the government for $10,000 and the current interest rate is 1%, I will get $100 a year until the end at which time I will get my principal back. This is the agreement we make with the Fed. If we want to hold our bond to maturity, this will not change. However, the face value of that bond ($10,000) will fluctuate during its life. What I mean is that if at some point you want to sell your bond on the open market (yes, you can trade your bond for cash just as if you bought Apple stock and now choose to sell it). The price a buyer is willing to pay will be based on several factors, but in this case, the two important factors are current interest rates and time until the bond matures.
In another example, you purchase a 10-year treasury bond for $10,000 and it will pay a 1% annual rate of return. However, the day after your purchase, interest rates fall and now the treasury is selling its 10-year treasury bonds and only paying .5% annual rate of interest. That means a buyer of a bond today will only get $50 per year, where you purchased it yesterday and are getting $100 for the next 10 years. You can now sell your bond on the open market for a higher price than you paid because the value of your bond is greater as interest rates fall and there is a lot of time left until your bond matures. Who wouldn’t want to get $100 per year instead of $50? Your bond might have a value of $10,322, an increase in value of 3.2% in a day. However, that value can only be locked in if you sold your bond. If you held it for 10 years, you would be stuck with the original agreement you made with the Fed.
The opposite is also true. If, in the same circumstance, rates spike to 2% overnight and you are stuck holding a bond for 10-years that is paying a lousy 1%, while the rest of the world could buy the same bond and get $200 per year, you may want to sell. However, when you contacted a broker to sell your bond, you may be disappointed to learn that overnight, the value of your bond fell from $10,000 to $9,678. You lost more than 3% on the value of your bond simply because nobody wants your lousy 1% bond in a 2% world. Again, if you hold the bond to maturity, you will get the full $10,000.
It is important to remember that time is always a factor. The longer the duration (time remaining on the bond until it matures) the greater the fluctuation in the bond price. Essentially, I would much rather have a bond that pays 1% for 5 years if rates go up to 2% than one that keeps me stuck at 1% for 30 years.
Price fluctuations for individual bonds are only on paper. If you hold the bond to maturity, you will get the full value so the fluctuations could be irrelevant to your portfolio.
Bond Fund: In a bond fund, a manager holds all types and durations of bonds. These bonds are constantly maturing with new money coming in to purchase new bonds. Thus, there is no yield to maturity because the fund never matures. The bonds that are either being sold or mature are being replaced with new bonds. Essentially, the bond funds life span is infinite. Thus, the only way to get your money out of a bond fund is to sell the fund. The bond fund will fluctuate in value in a very similar fashion to the individual bonds that make up the fund (i.e. a long-term treasury bond fund will do very well when there is a financial panic, interest rates collapse, and people run for safe investments). However, the fund will fluctuate based on the duration of the fund, interest rates, and the underlying economic conditions affecting the fund.
As a portfolio manager and financial planner, I prefer to see bond funds in a diversified portfolio versus individual bonds in most cases. The fluctuations of the bond fund are exactly what a well-balanced portfolio needs to offset the fluctuations of the stock (equity) investments in the portfolio. Since bonds tend to have a negative correlation to the stock market (when stocks fall, bonds tend to rise….and vice versa), they provide a fantastic hedge. Especially to retirees.
Although this topic can be a bit technical, it is important to understand at least the fundamentals when investing in bonds. Please understand that when you put your hard-earned money out into the world to work for you, you take risk no matter what you invest in. The key to proper investing is to understand the risk you are choosing to accept in investing that money. Knowledge is powerful!