Let’s say you are on the conservative side and decide bonds appeal to you. You are not going to live forever, so a long-term bond is out of the question. You have a choice between US Treasuries, corporates, and various mutual funds. It is tedious to follow individual bond pricing, and most people tend to rely upon a recommendation from their broker. Regardless of the method you arrive at a specific bond investment, many people feel safe and contented knowing their interest and principal are guaranteed.
That being said, if you hold a your investment until maturity you will receive interest and the return of your principal. What if you need your money before your bond matures? Will you be able to sell and get all your money back? Well, that depends on a variety of factors; the most important factor is the direction interest rates have moved since you purchased your bond.
If rates have risen since you purchased the bond, you will receive less than you initially invested. If interest rates have fallen, you will receive more than your initial investment. There is an inverse relationship between bond yields and bond prices. When rates rise, your bond is worth less. If interest rates fall, you will receive more than your initial investment.
Bond funds are also susceptible to principal price fluctuations, and the same thing happens in these funds as investors experience in individual bonds. It stands to reason that the longest term bonds tend to be the most volatile as there is no way to ascertain what rate fluctuations can occur over a 30 year period of time. As maturities shorten, there is less rate fluctuation.
I should also note that junk bond valuations are more often a function of the underlying guarantor of the instrument, as oppose to rate fluctuations, though they are susceptible to rate fluctuation, too. Junk bonds tend not to fluctuate in price with rates as high grade corporates as they are often priced and traded on the fundamental condition of the issuer.
How much can you expect to lose if interest rates rise?
In a bond fund, you can check the average maturity of the bonds held in the fund’s portfolio and roughly equate that number to basis points of loss for each 1% of rise in the current yield. Let’s assume you are in a bond fund that has an average maturity of 5.4 years. So, if a market bond yields climb 1%, your bond will decline 5.4%, in theory. It doesn’t always work perfectly, but it’s a very good method for estimating potential for earning when investing in bonds.
Logically, bond funds perform well in a time of falling interest rates and underperform when rates are low, as they have little room to fall.
In summary, I have said that bonds pose no risk if you hold them until maturity. However, should you need to liquidate your investment before maturity you stand realize more or less than your original investment. Rising interest rates force bond prices down and falling interest rate cause bonds to appreciate. This also holds true for bond funds.