Investment Warrior Report Archive Article

The Danger of Bonds

The vast majority of investors do not understand the relationship that bond prices have with interest rates. They donít realize that when interest rates are rising, that the value of their bonds and bond mutual funds actually decrease in value.

Here is how this occurs: If someone buys a 30 year government bond at a par value of $1000 that pays 5%, ($50 a year), and interest rates rise to 6%, then why would a new buyer pay the full value for this bond that only pays $50 a year, when he could buy a brand new $1000 bond that pays $60 a year? Common sense says that you would be better buying the new higher yielding bond. In order for the old bond to remain competitive in the marketplace, the price must be discounted to match the new rate of 6%. In this example, the 5% $1000 bond would have to be sold at $863, in order to now yield 6%.

Of course the opposite is true too! When interest rates decline, the value of bonds increase. Here are a couple of examples of how this has worked in both rising and falling interest rate environments: in 1999, as the Fed raised rates to slow down the economy and tame the stock market bubble, long term Government bonds lost 13% of their value. In 1985, when the Fed was lowering rates aggressively from levels of the high teens in the early 1980s, these same bonds would have gained an impressive 36.34%!

With the many reductions in short term rates since 2000, and with the worst bear market since the Great Depression, money has flowed to bonds and bond mutual funds. With more than $65 Billion in assets, Pimco Total Return bond fund is now the largest mutual fund in the nation, even surpassing the Vanguard Index 500 stock fund. Realize that a falling dollar and a recovering economy will put pressure on interest rates. It is possible, if not likely, that as soon as the middle of 2003, bonds could be under considerable pressure. Remember, the crowd is generally wrong at turning points, and we have been at generational 40 year lows on interest rates.

Although interest rate movements are much less volatile than stock movements, it still pays to use mathematically tested, empirical timing systems such as those used in the Lussenheide Investment Warrior Report to manage the risk of rising interest rates and the loss of capital value in bonds.