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Why Are Bonds Losing Money?

April 12, 2022
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Why Are Bonds Losing Money?

Bonds are a type of investment that pay a fixed rate of interest to the bondholder over a period of time. Most bond investors hope for slow steady returns. No one gets into bond investing looking for a "wild ride". That being said, a wild ride is exactly what we see in the bond market right now. Why? Well - the Federal Reserve, in an effort to hasten the ascent of inflation started raising interest rates at a breakneck pace. What does the Fed raising rates have to do with bond investing? Read on and I'll tell ya!


The Short Version:

When interest rates in the economy rise, the fixed interest rate on existing bonds becomes less attractive to investors compared to new bonds that are being issued with higher interest rates. This causes the price of existing bonds to decrease, as investors are willing to pay less for them. I suppose I could end the blog right there. Re-read those two sentences about 3 times and you can answer the question of why bonds are losing money. If you want the deeper dive, keep reading.

The Detailed Version:

When interest rates rise, it's typically because the Federal Reserve is trying to control inflation or slow down economic growth. Bond prices (what a bond is worth) have an inverse relationship with interest rates. As interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. Think of a teeter-totter with bond prices on one side and interest rates on the other. Both side move in opposite directions.

This is because the fixed interest payments on bonds become less valuable as interest rates rise. Think about it if you can earn a higher interest rate on a new bond, why would you buy an existing bond with a lower rate for full price? You wouldn't, you would need to buy it at a discount to make up for the below market interest rate it now pays. As a result, bond holders have seen the value of their bonds decline as interest rates have risen. 

It is worth noting that not all bonds are affected equally by changes in interest rates. This is an effect of something called duration. How long is the maturity of the bonds that you own? Shorter term bonds are less affected by higher rates than longer term bonds. This is because long-term bonds have a longer time until maturity, so their now below market interest payments will be worth less for a longer period of time.

An example - if you own a bond with 1 year until maturity and rates go up - the price will decline but not substantially because you only need to "subsidize" one year of a below market rate before you or the person you sell the bond to get their original principal back due to the bond maturing. Likewise if you own a 10 year bond and rates rise the value will drop substantially more before you have 10 years of a potentially below market interest rate to make up for.

 

In conclusion, when interest rates rise, bonds decrease in value because the fixed interest rate on existing bonds becomes less attractive to investors compared to new bonds that are being issued with higher interest rates. This causes the price of existing bonds to decrease, as investors are willing to pay less for them. Additionally, bond prices have an inverse relationship with interest rates, so as interest rates rise, bond prices fall, and as interest rates fall, bond prices rise.


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