The Hidden Risk In Bonds

Recent volatility in the stock market has many investors looking for “safety”. Many turn to government bonds. But is now the right time to invest in these notes? Today we’ll talk about the hidden risk in bonds.

Podcast: The Hidden Risk In Bonds

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To understand the hidden risk in bonds, there are two important concepts.

Key Concept 1: Yield

When talking about bonds, the first key concept is yield. Yield is the return you will earn when you buy a bond. It factors in the current price, the interest rate, the date it matures, and the return of principal.
 
If you buy a bond with a 2% yield and hold it until maturity, that is the return you will realize.

Key Concept 2: The Relationship Between Yield and Price.

The second concept is the relationship between yield and price. Bond yields and bond prices are inversely related. This means when bond prices go up, yields go down. And when yields go up, prices go down.

Where is the Hidden Risk In Bonds?

Bond yields are near historic lows. And it is hard to imagine them going lower. When they increase, it could create a very difficult situation.
 
Those who buy these longer term notes will face two choices. The first is to accept a low rate of return over the next several years. The other option is to see the value of their investment decline as yields move higher.
 
Let’s show you an example.
This is an actual bond quote from Monday, August 12.  (Click image to enlarge).  This note matures in May 2029.  The yield was 1.595%.  If you purchased this bond your price was 107.  

Hold it until it matures

If you hold this note until maturity, you will earn 1.595% over the life of this bond.  You’ll collect the interest payments, and most likely the principal.   (US Government bonds are backed by the full faith and credit of the United States).  

What if Yields Go Up?

Though complex, you can calculate the price of a bond if yields change.  What happens to the price of this bond if yields increase to 2% in 60 days?
 
The price will drop, remember the inverse relationship. In this instance, the price drops 3.5% to 103.26
Hidden Risk In bonds

The moves can be more extreme if yields increase even more.  In this example, we show what happens to the price if yields increase to 2.5% in 6 months.  

The price of this bond drops to 98.68, a decrease of 7.5%

Hidden Risks Bonds

If yields move high enough, the price decrease can be more like a stock investment.

Here we show what happens to the price of this note if bond prices move to 3% in one year.  

A price decrease of 11% is not what anyone bargains for when they buy a so called “safe” investment.

Bond risk

Lower Return, Higher Risk

Right now, longer term bonds present a low return, higher risk environment. Investors buy these because they think they are safe. And if you hold this note until it matures, you’ll collect the interest and get your money back.
 
But you lock in a low return—1.6% over 10 years is not attractive. In the meantime you’ll see the value of this bond decrease when yields increase. And if you sell it before 2029, you’ll likely incur a loss.
 
This is why we have been using short term bond investments—with maturities of 1 year or less. There is less price fluctuation, and fewer opportunities for big price decreases as yields move higher.
Financial Planning

Neal Watson is a Certified Financial Planner™ Professional and a Financial Advisor with Fleming Watson Financial Advisors  He typically works with people who are planning for retirement.  Fleming Watson is a Registered Investment Advisory firm located in Marietta Ohio.  Our firm primarily serves Marietta, Parkersburg, Williamstown, St. Marys, Belpre, Vienna and the surrounding communities in Washington and Noble Counties in Ohio and Wood and Pleasants county in West Virginia.

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