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?
A sensible investor would demand the same 10% yield paid by the new bond. Otherwise, it would make more sense to buy the new one. That means the older bond would sell for $500, because then its $50-a-year payment would be 10% of its price. So the doubling in yield would cause the bond's price to fall by half.
In real life, the effect isn't this pronounced because other factors are at play. But for a bond with many years to maturity, it is possible for a 1 percentage-point increase in prevailing rates to cause a 10% drop in price. (The effect is not as great with short-term bonds because the principal will be repaid sooner, allowing the investor to reinvest at the new higher rates.)
To view the risk of loss on a specific bond or bond mutual fund, look for a figure called "duration," expressed in years. A five-year duration means the bond or fund can be expected to lose 5% of its value for every 1 percentage point rise in rates.
What all this means is that at a time of rising interest rates bonds become riskier. What you earn in interest can easily be offset by a loss in principal. You can avoid that loss by holding the bond until it matures and the issuer repays your principal, but that means living with a below-market yield until then.
This is why many financial advisers are warning against investing in bonds now. In recent decades the whole process has worked the other way, with falling rates driving bond prices up. Now the party seems to be over.
It's a tough environment for fixed-income investors, and for long-term investors who have relied on the classic 60/40 split between stocks and bonds.
In this environment, bank savings look pretty appealing as a bond alternative. Interest earnings are skimpy, but your principal is guaranteed against loss by FDIC insurance.
And cash stored safely in bank savings is accessible ready to be invested when market conditions look better.
--Written by Jeff Brown for MainStreet