A misunderstanding is that bond investments are not supposed to ever lose money. In fact, bond funds go up and down like stocks, just not with such extreme highs and lows.
A quick primer on bonds
Bonds are a way for a company or government to get a loan from the public. Loans are made for a specific period with a set interest payment that is communicated up front. Most bonds are issued in increments of $1,000.
If Walmart wanted to raise money temporarily to buy a new fleet of trucks, it could issue bonds for 5 years paying 4% interest per year. At the end of 5 years, the bond holders would get their original investment back. Buying 10 of these hypothetical Walmart bonds would cost you $50,000 and earn you $2,000/year interest until your $50,000 is returned to you at the end of 5 years.
But what if…?
What happens if you need your $50,000 back in Year 3 of the 5-year bond? Walmart isn’t going to pay you early, so you must go out and see if someone else will buy your bond investment.
You propose to your neighbor that he buy your bonds. Your savvy neighbor knows that new 5-year bonds are paying 6% interest. Why would he pay full price for your sad 4% interest bonds? He offers to pay $45,000 for your bonds and you accept. You have just lost money on your bond by not holding it to maturity.
Conversely, if you proposed the same transaction to your neighbor and new 5-year bonds were only paying 3%, you could ask for more than the $50,000 because he can’t get better interest now than what your Walmart bond pays. In this case you’ve made money on your bond purchase.
Transactions like these happen by the thousands every day in the bond market. This is why individual bonds and bond mutual fund prices go down when there is a whiff of the Fed raising interest rates.
The Federal Reserve now thinks the US economy is strong enough to handle higher borrowing costs, so they are slowly raising the target fed funds interest rate. This is bad in the short term for bond mutual fund holders because the value of their existing bonds goes down when interest rates rise.
Don’t despair!
Bond funds are constantly getting in new money, so the managers can buy new bonds at the new, higher interest rates. If you own individual bonds, the short-term swings in valuations don’t mean anything to you as long as you hang onto your bonds until they mature and your principal gets paid back to you by the bond issuer.
We hold bonds and bond mutual funds in our portfolios because they don’t go up and down as extremely as stocks. Also, when stocks are down bonds are usually up, so they provide diversification. But that doesn’t mean they never go down at all.
Hold tight, don’t sell in a panic, and talk to your financial advisor about rebalancing your account at least once per year.
