FAQ: Why are my bond funds losing value? I thought bonds were supposed to be safe?
Investors generally associate bond investments with price stability and safety. Even though bonds are considered conservative investments (especially when compared to stocks), bond prices fluctuate. However, it is important to note that bond prices historically have not varied as widely as stock prices. If you would like to learn more about bonds, please see my previous article: “Should Bonds Be Included in My Portfolio?”
One of the main things that cause bond prices to change is interest rates. Bond prices and interest rates have an inverse relationship with each other. When interest rates increase bond prices decrease, and vice-versa. Let’s take a look at an example that may help with understanding this relationship:
Let’s say you have $1,000 that you would like to invest in a bond. You have two choices available. The first bond is trading in the secondary market and will pay you 3% interest while the second bond is a newly issued bond that will pay you 5% interest. Let’s also assume that both bonds have identical risk characteristics. As an investor, who is looking to maximize your return, you would not purchase the 3% bond on the secondary market when you could invest the same amount of money in the newly issued bond that will provide more interest. Therefore, the market price of the 3% bond would have to decline in order for you to have a comparable return on the investment.
In addition, the price of a bond with a longer time to maturity is more sensitive to changes in interest rates than the price of a bond with a shorter time to maturity. Therefore, the price of a 30-year U.S. Treasury bond will experience more volatility than a 10-year U.S. Treasury bond given a similar change in interest rates.
So, you may be asking yourself; “with the recent increase in interest rates why would I invest in bonds?” One of the main reasons you would own bonds is to add a level of diversification to your portfolio. This diversification can be extremely helpful during periods of time when stocks are struggling. Bonds can act as a ballast to your portfolio during periods of falling stock prices, because during these times bond prices tend to stay stable or increase. This occurrence is known as the “flight to quality”. As stock prices decline, investors tend to sell their stock holdings and reinvest that money in bonds (especially high-quality bonds like U.S. Treasuries) in an effort to stabilize their portfolio.
When it comes to investing, the goal is to understand that the value of your investments (i.e. stocks, bonds, real estate, etc.) will fluctuate overtime but it is best to hold them for the long-term and try not to pay attention to the day-to-day price swings.