by Fred Fuld III
Have you considered moving out of stocks and into bonds to protect your investment portfolio? Think twice before you do.
Unless you are investing in Series I Bonds, you might want to avoid bonds at this time.
Remember, when interest rates go up, bonds drop in value. As a very simplistic example, If you have a bond paying 5%, and interest rates in general rise to 10%, a 30 year bond would drop to almost half its value.
Of course, you could sweat it out and hold on for 30 years to get your original investment back.
Even short term bonds can drop significantly, far exceeding what interest you have earned on the bond for the year.
You never know what the Federal Reserve Board will do with interest rates. Currently it looks like much higher rate hikes are in the cards due to rising inflation.
It looks like Fed Chairs are pushing for a 75 basis point (3/4%) interest rate increase for their upcoming meeting near the end of July hoping to help offset inflation.
So if rates continue to rise, how will it affect the value of your bonds?
The following shows what will happen to a 3% 30 Year Bond:
| Value of a 30 year bond | ||
| If interest rates increase | 30 year bond | |
| Interest rates | 3% bond | Drop in value |
| 3% | $1,000.00 | |
| 4% | $827.08 | 17% |
| 5% | $692.55 | 31% |
| 6% | $587.06 | 41% |
| 7% | $503.64 | 50% |
| 8% | $437.11 | 56% |
| 9% | $383.58 | 62% |
The following shows what will happen to a 3% 5 Year Bond:
| Value of a 5 year bond | ||
| If interest rates increase | 5 year bond | |
| Interest rates | 3% bond | Drop in value |
| 3% | $1,000.00 | |
| 4% | $955.48 | 4% |
| 5% | $913.41 | 9% |
| 6% | $873.63 | 13% |
| 7% | $835.99 | 16% |
| 8% | $800.36 | 20% |
| 9% | $766.62 | 23% |
The following shows what will happen to a 4% 30 Year Bond:
| If interest rates increase | 30 year bond | |
| Interest rates | 4% bond | Drop in value |
| 4% | $1,000.00 | |
| 5% | $846.28 | 15% |
| 6% | $724.70 | 28% |
| 7% | $627.73 | 37% |
| 8% | $549.69 | 45% |
| 9% | $486.32 | 51% |
| 10% | $434.39 | 57% |
The following shows what will happen to a 4% 5 Year Bond:
| If interest rates increase | 5 year bond | |
| Interest rates | 4% bond | Drop in value |
| 4% | $1,000.00 | |
| 5% | $956.71 | 4% |
| 6% | $915.75 | 8% |
| 7% | $876.99 | 12% |
| 8% | $840.29 | 16% |
| 9% | $805.52 | 19% |
| 10% | $772.55 | 23% |
Why Bond Mutual Funds are Bad
The worst possible bond investment during rising interest rates is a bond mutual fund. The reason?
There is no yield to maturity.
What that means is, if rates rise after you invest and never drop to that level again, then it doesn’t matter how long you hold onto the fund, even 50 years. You won’t get your principal back.
What can make it worse for the funds is if there are a lot of redemptions as interest rates rise and drop in value.
The fund is then forced to liquidate bonds at losses, thereby locking in losses for the whole portfolio.
Summary About Bonds
So if you have bonds in your portfolio, or you are consider buying bonds for your portfolio, make sure that you are aware of the downside.