Understanding Bonds: The Importance of Holding Strong
It’s a question I hear from clients often: Why are my bonds losing money? The answer has nothing to do with the bonds themselves, but with the interest. While some might think bonds have an inverse relationship to the stock market, the reality is that relationship exists only between bonds and interest rates.
The term ‘duration’ refers to the sensitivity of the price of your bond investment to the fluctuation of interest rates. The higher the duration number, the more sensitive your bond investment will be to changes in interest rates.
Think of it like a seesaw. When interest rates rise, bond prices fall. When interest rates fall, bond prices rise.
For example: a bond paying a 3% non-callable coupon will continue to pay 3% interest until maturity. If interest rates were to rise to 4%, the value of the bond will decrease proportionately to the rise in interest rates to equate to a 4% yield. This is only a problem for the bondholder if they need to sell the bond prior to maturity.
The reverse is also true: when interest rates fall, that same bond will appreciate in value,
For a person not in finance a good way to see what is going on with interest rates is to see what the 30 year fixed rate is. You can always check bankrate.com. For example, April 2013 rates were around 3.6% if you went to refinance or buy a new home. If you went today they would be around 4.8%. That is over a full point difference which means your bonds would have gone done during that period. If you held individual bonds to maturity you always get your principal back and get your stated coupon rate no matter what is happening with interest rates.
People don’t like to lose money, even if it’s just on paper; that’s just human nature. The important take-away here, though, is that the face value of a bond will come back to you if it’s held to maturity. Just like a see-saw, it’s best to get off the ride when everything is level.
A guest post by Cary Carbonaro, MBA, CFP®, Managing Director, United Capital of New York and New Jersey. She is the author of the “The Money Queen’s Guide: For Women Who Want to Build Wealth and Banish Fear” #1 New Release and #1 Best Seller in Wealth Management. For more info go to www.moneyqueenguide.com.
This article is intended for informational purposes only. We recommend that you discuss these ideas with your tax adviser. United Capital does not offer tax or legal advice; therefore, this article should not be taken as such.