Some Bond Questions and Answers

Why are “safe” bonds losing money this year?
The tailwind to bond investing has turned into a headwind this year. The wind we are referring to is the direction of interest rates. Interest rates on bonds have been on a three decade long decline. Because of this, bond investors have essentially received a bonus in the form of a price appreciation through this period.

With interest rates starting to climb, the bonus has become a penalty. Interest rates on the 10-year Treasury bond have risen from 1.78% at the end of 2012 to 2.72% as of September 23, 2013 (source: St. Louis Federal Reserve). This has resulted in a -5.5% year-to-date total return for 10-Year Treasury bonds (source: Wall Street Journal). The 10-year Treasury bond is still considered “safe” from a credit standpoint since the U.S. government can pay back the face amount of the bond, but that doesn’t mean the bond price could not change dramatically over any given holding period.

Why do bond prices go down when interest rates go up?
We have written in the past about the inverse relationship between bond prices and interest rates. While the terms (e.g., the interest rate, credit quality and maturity) of most bonds don’t change over time, the price people are willing to pay for a bond does. Bond prices adjust to changes in interest rates. All things equal, bonds with low interest rates will decline in value when bonds with higher interest rates enter the market. And all else equal, investors prefer the higher interest rates of the new bonds, so existing bonds decline in value until investors feel the total return between the two bonds is the same.

Should I sell my bonds?
Everyone’s situation is different, but bonds are typically a core part of a well diversified portfolio. They traditionally exhibit dissimilar price movements to other investments like real estate and stocks. This dissimilar price movement is key to effective diversification over the long term. This year, many bond positions are down, but many stock positions are up. In years past, when stocks were down we would rebalance a portfolio by selling bonds and buying stocks. That trend has reversed this year. Depending on the portfolio, stocks are being sold and bonds are being purchased in a typical rebalance. This is an example of buying low and selling high.

Additionally, bonds also provide income, which is a positive contributor to total return, and shorter-term bonds have lower volatility. There are a wide variety of bonds available to investors, and some bonds are better for a rising rate environment than others.

Past performance is not indicative of future results.

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