The Secret to Buying and Owning Bonds
By Ric Edelman
When it comes to earning interest on your money, nothing is as safe as your bank account. But banks don’t pay very much interest, and your purchasing power is likely to diminish if you keep your money there.
On the other hand, you can invest in stocks. But they have drawbacks, too, mostly because the stock market can be volatile. As a consequence, you can lose a significant portion of your money.
For a lot of investors, especially those looking for steady income, bonds are the happy medium. But even these investments aren’t free from risk, especially when interest rates are somewhat volatile.
During volatile periods, bondholders are exposed to what’s called interest rate risk. Without question, this causes more investors to lose money than any other type of investment risk. There is a way around it, but before I discuss that method, let’s look at why bonds are so attractive and how they behave during periods of fluctuating interest rates.
A Compelling Reason to Own Bonds
Harry is home having dinner when the phone rings. It’s a cold-calling stockbroker. (They know when you’re likely to be home!) The broker says, “Harry, instead of keeping your money in the bank at 2% interest, I can give you a bond issued and guaranteed by the U.S. government that pays 5% interest annually, pays that interest on a monthly basis -- just like a Social Security check -- is free from state income taxes, and is liquid at all times. Harry, what I’m offering you is safer than the bank, earns more interest than the bank, is as liquid as the bank, and lowers your taxes. What do you say? Can I put you down for $10,000?”
Pretty appealing, isn’t it? And everything the broker says is true. Government bonds are safer than banks, they do pay higher interest rates, they are lower in taxes, and you can sell them whenever you want.
However, the liquidity part of that pitch is a bit weak, and is the cause of more investor losses than anything else on Wall Street. Here’s how it works: Say Harry accepts the pitch and invests $10,000 to buy that government bond with its 5% interest rate and $10,000 face value. Let’s further say that two years later he decides to sell his bond, because he needs the cash to buy a car. Let’s also say that during this time, interest rates have changed, and the government is now issuing new bonds with a 7% interest rate.
Enter Jane, another investor. She is interested in buying the same type of bond that Harry happens to be selling. This presents Jane with a choice: She either can buy Harry’s government bond from Harry, or she can buy a brand new one from the government. Since both have a face value of $10,000, which one will she buy: Harry’s, offering a rate of 5%, or the new government bond, which offers 7%?
It should be obvious that Jane will buy the new government bond, which pays 2% more than Harry’s bond. But this next question is a bit more difficult: What must Harry do to convince Jane to buy his bond instead of the government’s? He cannot change the interest rate of his bond. After all, that’s set in stone; 5% is printed right on the certificate itself. The answer: Since he can’t increase the rate of his bond, Harry must lower the price. He must sell his bond for less than its $10,000 face value.
How much less? Well, in this example, for Jane to make as much money on Harry’s bond as she would have earned on Uncle Sam’s bond, she must buy it for $7,000. In other words, paying $7,000 for a $10,000 bond at 5% is equal to paying $10,000 for a $10,000 bond at 7%.
In this example, Harry must sell his bond for $3,000 less than what he paid for it! Try to explain to him how he managed to lose 30% of his money in a government-guaranteed investment!
This phenomenon is called interest rate risk, and, as I said, it is the biggest cause of investor losses in the world. It is also confusing to a lot of investors.
Picture a seesaw with interest rates on one end and bond prices on the other; as one side rises, the other falls. Therefore, had rates fallen to 4% instead of rising to 7%, Harry would have been able to sell his bond to Jane for more than he paid, instead of less. Thus, as a result of interest rate risk, bondholders can make, or lose, a lot of money. It all depends on which way interest rates go. But interest rate fluctuations aren’t the only factor affecting a bond’s price.
The longer a bond’s maturity, the more extreme it will swing in value. A 30-year bond fluctuates much more than a 1-year bond.
How to Beat Interest Rate Risk
There is a way Harry can avoid losing the $3,000. All he has to do is hold on to his bond. He loses money only if he sells; if he keeps his bond to maturity, the government will pay him the full $10,000.
Remember: The government’s “full faith and credit guarantee” is only for the “timely payment” of interest and principal. That means Uncle Sam will pay interest on time to whoever owns the bond, and, at maturity, will return the principal to whoever owns the bond at that time.
The government also says its bonds may be bought and sold before maturity, but is silent regarding the buy and sell prices, leaving investors to negotiate the price of the security among themselves. This is where the phrase, “negotiable security,” comes from: All stock and bond prices are negotiable between buyers and sellers.
If you think Harry’s predicament is merely hypothetical, recall the bond market of early 1993. Long-term interest rates had dropped to their lowest levels in 27 years, but in 1994 they rose 2.75%. That corresponded to a 27.5% loss for bondholders, the worst one-year loss in bond history. Estimates put total investor losses at about $1.5 trillion. In fact, it was the first time bonds had posted a negative total return in modern times, all due to interest rate risk.
This means you should buy only those bonds that feature a maturity date you can tolerate.
It is because of interest rate risk that bond yields don’t tell the whole story. That’s why you should never, ever buy an investment based on yield. Look at any personal finance magazine or the business section of any newspaper and you’ll see ads proclaiming high yields, but none of these ads adjusts the yields for any gain or loss in market value.
This volatility provides opportunity for high-risk speculators and gamblers to try to guess which way interest rates will move next. Thus, you’ll find the biggest institutional players in the bond market, not in the stock market. Indeed, in 2012 the daily average of stocks traded in the U.S. was $123 billion, while the daily average on bonds traded was $843 billion – the bond activity was nearly ten times higher than stocks.
With Interest Rate Risk to Contend With, Should You Buy Bonds?
Before you buy a bond, ask yourself: what are the chances that interest rates are headed up or down over the next couple of years? After all, rates can do one of three things:
1) go up
2) go down
3) stay the same.
If rates rise, your bonds lose value. If rates fall, your bonds grow in value. If rates stay the same, the bond’s value stays the same. Thus, only one of these three scenarios (rising rates) places you in jeopardy.
If you believe rates are likely to rise, does this mean you should not buy bonds? Not at all. First of all, you’re probably wrong (simply because most investors are. As Barron’s once put it, “If the majority were right, the majority would be rich.”) Second, bonds are a cornerstone of any diversified portfolio. So, don’t avoid bonds because of interest rate risk. Instead, just be aware of how and why their value changes.
Originally published in Inside Personal Finance March 2001