Bond Risks Rising

NEW YORK (MainStreet) —Stock and bond markets have been reeling since the Federal Reserve suggested it might soon start winding down the stimulus program that has helped to keep interest rates low. If you've been frustrated by low yields on bank savings and bonds, that might sound like good news. Then again, you might be careful what you wish for, since a gain in interest earnings could be wiped out by a big investment loss.

For years, the Fed has used various strategies to stimulate consumer and business spending by keeping interest rates low. Now that the economy is perking up, the Fed may pull back and let rates on bonds, bank savings, mortgages and other loans drift back up from today's near-record lows.

Anticipating this, the financial markets have started to nudge rates up. The 10-year U.S. Treasury note, for example, now yields about 2.4%, up from less than 1.7% in early May. If you put $100,000 into these bonds today, you'd earn $2,400 a year, up from $1,700 if you'd invested the same amount six weeks ago. That's a 40% increase in interest earnings.

Sounds good. So what's the problem?

It's a problem because as prevailing rates rise, they drive down the prices of older bonds that paid stingier yields. That drop is affected by many factors, such as how long the bond has until maturity, the yields at which interest earnings can be reinvested, and the market's view of the default risk — the chance the bond issuer will not make the interest and principal payments promised.

Here's a highly simplified example of the relationship between yield and price. Imagine that yesterday a new $1,000 bond yielded 5%. It would pay $50 a year. Now suppose a new $1,000 bond was available today, paying 10%, or $100 a year. What would investors now be willing to pay for the older, stingier bond?