The risk of bonds
Date posted: July 31, 2013
Bonds are a key investing option. But recently there’s been a lot of discussion of the impact of rising interest rates and bonds and the returns that investors in bonds might make. N.C. State University economist Mike Walden explains.
“Traditionally bonds have been considered a very safe investment, particularly if you buy government bonds. And the way a bond works is simply that you turn over an amount of money, let’s say $1,000. The issuer of the bond promises to pay you a certain amount of money per year — let’s say on that $1,000, it’s $30 a year. That works out to be a 3 percent rate of return. Then when you sell the bond when it comes due, you cash in the bond, you get your $1,000 back. People view that as a very simple proposition – (a) very safe way to earn money.
“Now the problem comes in if you want to sell your bond before its due date, which is very, which is very, very typical. That’s done all the time. Then you have to worry about … the interest rate you’re earning on your bond, which is going to be fixed, and the interest rate on new bonds. Obviously, if someone is looking at buying your bond and paying 3 percent, whereas if they can turn around and buy a brand new bond that’s paying, say, 4 percent, they’re not going to pay you your $1,000. They’re going to pay you something less.
“So people who have bonds that are paying below market interest rates when they try to sell them, they’re going to … take a loss. And that is an issue … that many people right now are facing because interest rates on long-term bonds are going up.
“So this is a risk of bonds that people need to consider. And it’s a risk that I think many are not aware of.”
Category: Economic Perspective