Interest rates and bond prices move in opposite directions. Treasury bonds are issued with a coupon rate, which is the amount of interest they pay each year. Recent 10-year Treasurys were sold with a coupon of 3.125 percent, paying $31.25 in interest on a $1,000 investment every year. After 10 years, the original investment of $1,000 is returned.
Traders seem to believe that there will be no inflation over the next 10 years and are willing to pay more than $1,000 for each 10-year note.
Recent prices were above $1,260, driving the yield down to 2.65 percent. The price is higher at the lower yield because no matter what you pay for the bond, the Treasury still sends interest payments totaling $31.25 every year.
If interest rates go up, a possibility if inflation rises, the value of bonds will fall. Traders will be paying less for bonds because if inflation rises above 3.125 percent, there isn’t any profit from the interest.
If interest rates go up by as little as 0.5 percent a year, the bond would fall in value to $1,000. Bond holders would lose 26 percent on their bonds if that happens, and they’d be receiving interest that doesn’t really even keep with inflation.
Yields were about 5 percent in the summer of 2007, before the financial crisis led to bailouts and quantitative easing programs that have ended. If the interest rate went back to 5 percent, the price of the bonds would fall to about $600, more than 50 percent lower than they are today.
Investors think of bonds as safe investments. They are in the sense that you’ll get your money back when the bond matures. The problem is that your buying power will be reduced by inflation. If you sell before maturity, you could face significant losses.
Conservative investors should look beyond bonds to avoid possible losses of half the principal in their accounts.
© 2012 Moneynews. All rights reserved.