THE WALL STREET JOURNAL
Buried deep in section D, Page 13*, you would uncover an outstanding article that clearly reveals a universal truth about bonds. “Many investors looking for safety and higher returns might falsely assume bonds are riskless investments, not realizing that even a modest increase in interest rates would take a serious bite out of fixed income values.”
Who’s making these statements?
The 2nd largest bond fund manager – The Vanguard Group.
Vanguard realizes the folly of many investors who do not understand they can lose principal if interest rates head higher. Vanguard rightfully warns investors, “…the value of a long-term bond fund might fall 20% if rates went up just two percentage points.”
In spite of these warnings and the fact interest rates are near historic lows, investors continue to flood money into risk laden bond funds. It is important to know this financial principle: Rising interest rates reduce bond values. It is a hard cold fact.
Author Ken Little from “About Money” is well aware of this relationship between rising interest rates and loss of bond value. He clearly states, “The biggest economic threat to bonds is rising interest rates.”
Do you believe interest rates are heading higher in the future?
Let’s examine an easy to understand example…
Imagine a bond was issued for $10,000. It has a five year term with a 5% coupon or interest rate, paid every six months.
Then, let’s imagine the market interest rates rise from 5% to 6%. If you want to sell this bond, would anyone buy it from you when it is paying 1% below market rates (5% vs. 6%)? That buyer could go elsewhere and just buy a 6% bond.
To get your bond sold, you will need to sweeten the deal so the buyer gets a competitive rate for buying your bond.
The problem is, you cannot change the interest rate on your bond. That’s locked in at 5%. What you can do, however, is change the price you will accept for your bond.
Here’s how you do it! Reduce your price so the annual interest payments of $500 ($10,000 x 5%) must equal a 6% payment.
This is called selling at a discount. To get the buyer a market rate of interest (6.0%), you must sell your bond at a discount for just $8,333. Now, the $500 fixed interest payment equals a 6% yield for the buyer of your bond…
While interest rates only rose by 1% in this example, your bond value reduced by a surprising 16.67%.
As an alternative, you may consider the safe haven provided by traditional fixed rate annuities. In most fixed annuities, the insurer accepts the market risk allowing the annuity owner to enjoy true safety and tax-deferred growth. Or consider the opportunities created by a Fixed Indexed Annuity. These innovative products provide you the potential to exceed traditional fixed interest rates without exposing your principal or past interest credits to market risk.
*(Source: The Wall Street Journal, March 19, 2003, Section D, Page 13)
“PLEASE NOTE: This is just an example to illustrate the relationship between interest rates and bond prices. It does not represent an actual computation. To do this calculation correctly would require a more complicated process and the answer would be different. However, the seller would still have to discount the face value of the bond to compensate for the interest rate difference.”