Archive for Sunday, August 3, 2003

Bond prices can and do fall when interest rates rise

August 3, 2003

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Aren't bonds supposed to be the safe place to stash your cash?

Then why have investors in 10-year Treasury bonds -- the gold standard in government-backed securities -- lost 8 percent of their money in the last month?

Those bonds, and many others, have fallen in price because prevailing interest rates have begun to rise. Imagine a seesaw: When the interest-rate side rises, the price side falls, and vice versa. Some experts believe bond prices have been in a bubble, just as stocks were a few years ago, and that it's starting to burst.

People who own bonds and bond funds could suffer enormous losses if rates continue to rise, and the upward movement could push mortgage rates up as well.

Basically, a bond is a loan. Buying one for $1,000, for example, means lending that amount to the governmental body or corporation that issued the bond. In exchange, you are paid interest for a given number of months, years or decades.

Then the bond "matures" and you get your $1,000 back. But if you want to sell the bond before maturity, you may get more than $1,000, or less, depending on how badly other investors want your bond.

Bonds are mystifying, in part because they aren't traded on central exchanges like stocks, and because there are so many different types. A corporation that has just one stock may have a whole string of different bonds, each moving up and down in price differently from the others according to factors such as default risk, inflation risk, maturity dates and call dates.

The biggest factor governing bond prices is changes in prevailing interest rates. If you had paid $1,000 for a bond with an interest rate, or yield, of 3 percent, you'd earn $30 a year until the bond matured. But if new $1,000 bonds paid 4 percent, or $40 a year, no one would give you $1,000 for your older bond.

Your bond's price would fall until that $30 annual payment came to 4 percent of the price. So the bond price would fall to $750, since $30 is 4 percent of $750. Other factors usually reduce the damage, but that's the idea.

In fact, this is what has happened in the last month. The yield on the 10-year U.S. Treasury bonds has gone from just over 3 percent to just over 4 percent, dragging the bond's price down by 8 percent.

Prevailing rates have gone up for a variety of reasons, most having to do with bond traders' belief that the economy will perk up, which usually causes rates to rise. Another factor is the rising federal budget deficit, which could force the government to sell more bonds to borrow money -- and to pay higher rates to attract more bond buyers.

The big stock market rebound since March has led many investors to shift money from bonds to stocks. Lower demand causes bond prices to fall.

All this has been quite bad for bond owners, including small investors who own bond mutual funds. Since mid-April, the average long-term U.S. bond fund has returned 1.18 percent, with both price and yield taken into account, while the average stock fund has returned 12.36 percent, according to Lipper, the fund-tracking company.

This is the reverse of last year's pattern, when steadily declining interest rates caused bond prices to soar, while stocks racked up their third straight year of losses.

Unfortunately, the typical investor jumps on the hottest investment of the moment, generally getting in too late. In 2002, investors took about $27 billion more out of stock funds than they put in, according to the Investment Company Institute, the fund trade group.

At the same time, they poured an additional $140 billion into bond funds. Through the first five months of this year, investors added $17 billion to stock funds, and nearly $63 billion into bond funds.

These investors could suffer deep losses if rates continue to rise. That will largely depend on how the economy does.

Still, rates remain low by historical standards. Hence, the odds favor rates going up rather than down.

Since mortgage rates tend to move in tandem with bond rates, they may well rise too. The 30-year fixed-rate mortgage has moved up about a percentage point, to about 6 percent, during the last few weeks.

Something unexpected could drive that rate down, but mortgage shoppers who hold out for better deals may end up with worse ones instead.

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