If interest rates were to rise and new $1,000 bonds paid 6%, no one would pay full price for your stingy old bond.
The math used to figure bond prices is very complicated, but for a simplified example, imagine that old bonds paid 5% and new ones 10%, with each initially selling for $1,000. The old bond would pay $50 a year, the new one $100.
After rates rose to 10%, the price of the old bond would fall to the point that the $50 coupon equaled 10% of the price. The old bond would sell for $500 rather than $1,000, and the investor who sold at this point would have lost half of his principal.
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Of course, it works the other way as well. If yields fall, older bonds which are more generous than new ones will rise in price.
Changes in interest rates have a bigger effect on bonds with many years to maturity, since the investor will be affected longer. A $1,000 bond that matures tomorrow will be worth $1,000 today even if its yield were far below what new bonds pay. But if there are 20 or 30 years to maturity, changes in interest rates will have a big influence on prices.
Because interest rates are relatively low today, they are more likely to rise in coming years than to fall. Fixed-income investors can minimize risks by sticking with holdings that mature in a couple of years or less.
Two-year Treasury notes yield about 1.25%, and one-year notes just 0.47%. At those levels, yield is hardly worth thinking about. Treasuries’ chief benefit is protection of principal.
And if that’s your concern, it might be simpler to put your money into government-insured certificates of deposit. Two-year bank CDs average 1.57%, according to the BankingMyWay.com survey. You can find even better deals using the BankingMyWay shopping tool. Discover Bank (Stock Quote: DFS) has a two-year CD yielding 2.25%, and Bank of Internet (Stock Quote: BOFI) pays about 2%.
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—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.
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