By Sheryl Rowling
SAN DIEGO–A question and answer session on bonds:
Q: Bonds are so confusing! Oy! How are my bonds affected when interest rates rise?
A: In general, when interest rates rise, the prices of bonds drop. When interest rates drop, the prices of bonds rise. So, if interest rates rise after you’ve paid $10,000 for a bond, your account statement will reflect an “unrealized loss.” In other words, if you were to sell your bond, you’d get less than $10,000.
Q: When rates go up, do all bonds lose value at the same pace?
A: No, interest rate changes don’t affect all bonds equally. Typically, the longer the bond’s maturity, the more it’s affected by interest rate changes. For example, a bond that matures in 10 years will usually lose more of its value if rates go up than a bond that matures in 2 years.
Put simply, a short-term bond is closer to the time it can be redeemed at face value. Let’s say that you own two $10,000 bonds that pay 6% interest per year. When interest rates rise to 8%, one bond matures in 10 years while the other matures in 2 months. The higher interest rates don’t really affect your short-term bond. You’ll get the full $10,000 by just waiting 2 months. On the other hand, if you sell your long-term bond right away, a buyer won’t pay $10,000 to you when a “new” bond will pay 2% more per year.
Q: What should I do with my current bonds? Should I hold onto them or sell them?
A: If you don’t need to sell your bonds, you’ll continue to receive your interest payments and you’ll get the full face value of the bonds when they mature. So, why sell?
Q: What if I need to sell my bonds?
A: Just remember that if interest rates have increased since the time you bought your bonds, selling before maturity will likely result in a loss.
Q: Can you give me an example?
A: Sure. Let’s say you buy a 10 year bond with an interest rate of 5% for $10,000. If you keep the bond until maturity, you’ll get $500 of interest each year for 10 years plus your original $10,000.
If interest rates increase and you sell your bond early, you’ll lose some money. Assume the same facts, except you sell the bond early when interest rates have risen to 7%. In this example, although you’d have received $500 of annual interest before the sale, you’d only get $8,800 for your bond.
On the other hand, if interest rates decline and you sell your bond early, you’ll generate a capital gain. Assume the same facts, except that interest rates have fallen to 4% when you sell the bond early. In addition to the $500 of annual interest before the sale, you’d get $11,250 for your bond.
Q: Why do my account statements show a loss if I haven’t sold my bonds?
A: Your account statements reflect market value – what you would receive if you actually sold your bonds. Let’s say you own a $10,000 bond paying 6% per year when interest rates increase slightly, causing the value of your bond to drop $200. In your annual account statement, your bond value of $9,800 will create unrealized loss of $200. Your cash balance will include the $600 interest received. So, when you only look at unrealized gains and losses, you will think that you lost $200 this year. In reality, your account grew by $400 – the net of the interest received and the unrealized loss. And, if you hold your bond until maturity, you won’t ever realize that loss!
Q: Why should I own bonds now?
A: It’s usually a good idea to maintain a diversified investment portfolio consisting of stocks, bonds, and cash. Bonds are a valuable part of a diversified portfolio because they provide a steady income stream, a predictable repayment of principal, and a counterbalance to the risks of stocks.
Q: My advisor recommends bond funds. Doesn’t that prevent me from holding my bond investments until maturity?
A: Yes, but if you’re planning to hold “laddered” bonds (bonds with different maturities), you’re probably going to buy a new bond as soon as one matures. Essentially, you’ll have your own “bond fund.” Whether you own individual bonds or shares of a bond fund, your portfolio will react to changes in the market interest rate. If interest rates rise, the values of bonds held by a bond fund will fall, resulting in an “unrealized loss.” However, the fund will continue receiving interest payments that are passed along to its investors. Bond funds have certain advantages over owning individual bonds – professional management and broader asset diversification.
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Sheryl Rowling is a certified public accountant, personal finance specialist, and principal of Rowling & Associates. She may be contacted via sheryl.rowling@sdjewishworld.com