Are bonds a safe investment? The answer is: Sometimes.
The recent financial crisis that brought capitalism to its knees has ushered in an extended period of historically low interest rates as the U.S. Federal Reserve Bank (the Fed) implemented policies that saved the economy but may have created an unsafe environment for bonds.
The Fed engaged in a policy of targeting interest rates at or below 0.25 percent. In addition, the Fed purchased trillions of dollars of fixed-income securities in an effort to keep rates low enough for as long as it would take for the economy to recover.
The theory is that lower interest rates would lower the cost of borrowing. The cheaper it is to borrow, the more likely a consumer or business will in fact borrow money, spend it and thus spur economic activity.
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One consequence of this environment is that interest rates on personal savings accounts have fallen to a dismal level. In addition, rates on everything from certificates of deposit and money markets to government, municipal and corporate bonds all declined as well.
Stretch and pull
Given historically low interest rates, many cash-strapped investors desperately sought out higher yields. Some found higher yields in lower-quality bonds. These types of fixed-income investments once carried the name "junk bonds," but today they are more fashionably referred to as "high yield."
Other investors discovered that bonds with longer maturities could provide higher yields as well. Instead of investing in a bond with five or seven years to maturity, investors stretched for yield and sought out bonds with 15- or 20-year maturities.
Since 2010, bond investors have generally experienced increases in fixed-income prices, while prevailing interest rates stayed stable or declined. This all changed in May 2013, when then Federal Reserve Chairman Ben Bernanke stated in a press conference that the Fed might cut back on the amount of bonds it purchases on a monthly basis. The word "taper" became the buzzword for the remainder of the year.
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The reaction was immediate. Should the Fed purchase fewer bonds, bond prices would fall. When bond prices fall, interest rates should rise. Complacent bond investors received a wake-up call, as 2013 was the first year in three that the annual return on the U.S. Long-Term Treasury bond was negative.
To understand the relationship between bond prices and interest rates, we will engage in a little child's play through the use of a playground seesaw. A seesaw is a long piece of board that has a fulcrum in the middle, so that when one side goes up, the other goes down.
Now, instead of children placed on either side of the seesaw, we will place bond prices on one side and interest rates on the other. As bond prices go up on one side, interest rates naturally go down on the other side.
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Conversely, when bond prices go down, interest rates on the other end go up. There are no two ways about it. The seesaw is sturdy, and the fulcrum, directly in the middle, provides for a balanced move on either side.
Moving the maturity
Maturities on fixed-income securities can range from months to decades. As mentioned, one way investors sought higher yields was by purchasing fixed-income securities with longer maturities.
Typically, bonds with longer maturities have higher yields. The problem is, the longer the maturity, the more sensitive the price of the bond is to interest-rate changes.
In our initial seesaw example, the fulcrum was placed directly in the middle, balancing the move between bond prices and interest rates. If we move the fulcrum from the center and over to represent a bond with longer maturity, the relationship between the movement of interest rates and bond prices becomes exaggerated.
Small upward or downward moves in interest rates may lead to much larger moves in bond prices; the longer the maturity, the greater the impact.
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The relationship between maturity and prices can be seen by comparing the 2013 total return for two U.S. Government fixed-income securities. The total return for the Barclays U.S. Long-Term Treasury Total Return Index was down 12.66 percent, but the Barclays U.S. Treasury Bill Total Return Index was actually up 0.10 percent. The longer maturity of the U.S. Long-Term Treasury Bond created a significantly greater loss than the shorter-term U.S. Treasury Bill during a period of rising interest rates.
Rise and raise
There is a fundamental difference between a rise in interest rates and the Fed raising interest rates. Interest rates were on the rise last year due in large part to the Fed talking about tapering its monthly bond purchases, which actually took effect in January this year.
The important part to remember is that the Fed has not yet taken the step of raising its target interest rates. The last time the Federal Reserve actually raised target interest rates was in 2006.
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The losses bond holders experienced in 2013 may occur again when the Fed actually starts to raise interest rates rather than just talk about a rise in rates. Fixed-income investors need to be aware that bonds may not always be a safe investment.
—By Ed Gjertsen II, Special to CNBC.com. Ed Gjertsen is a certified financial planner and vice president of Mack Investment Securities.