Bond Risks: How Long is Too Long?


Pssst... Want to make 4.4%, guaranteed?

That sounds pretty good in this time of low interest rates. According to surveys, money market accounts average just 0.44%, savings accounts 0.232% and one-year certificates of deposit only 1.141%.

Getting 4.4% on a 30-year U.S. Treasury bond sounds pretty good. Until you take a closer look. These days, it probably makes sense to stay away from fixed-income investments with so many years to maturity.

Even though Treasuries are guaranteed by the government, which has never defaulted on this kind of debt, there are big risks, depending on which of two investment approaches you choose.

Approach #1: Buy and Hold

The first is to buy with the intention of holding the bond until it matures. All bonds are loans from the bond buyer to the bond issuer. You pay, say, $1,000 for a bond yielding 4.4% and you’ll get $44 a year for 30 years, and then the government will return your $1,000 principal.

Many corporate and municipal bonds carry a risk of default, when the issuer fails to make the promised interest payments or fails to return the investor’s principal. With Treasuries, the default risk is all but non-existent.

The chief risk for the buy-and-hold investor is in having money tied up in the bond while other investments are more generous. If interest rates shoot up to 7% or 8%, you’d probably kick yourself for being locked in to 4.4% for three decades. Inflation is a factor, too. If it picked up to, say, 4%, your bond’s purchasing power would really be growing at just 0.4%.

Approach #2: Buy and Sell

Of course, you could always sell the bond to someone else. This is the second approach to bond investing, but it carries risks, too.

Although bond yields are expressed as a percentage, the annual coupon payments are fixed dollar amounts. The $1,000 bond yielding 4.4% will pay $44 a year for 30 years, but the bond itself might not always be worth $1,000.

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.

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 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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