How Bonds can be Painful

We have written on numerous occasions about the “risk” that many investors may be subject to, when they think they are investing safely. The Wall Street Journal published an article today, titled “Treasurys Can be Painful, as History Shows,” which clearly states the same point.

For investors that are purchasing or holding bond funds, and particularly bond funds that hold securities with maturities that are longer term, of greater than 5 years, they may face significant investment losses in the future, when interest rates rise.

As the WSJ article stated, as the stock markets have risen in September, 10 year Treasuries have lost 2.2% and 30 year bonds are down by 6.9%. Note that if interest rates rise, the price of bonds fall. If you own a bond to maturity, this should not be a major concern. If you own bond funds, this is a major problem, that should be discussed with us and corrected.

As we base our investment decisions on our understanding of how financial markets work, and not on predictions, we try to learn from the past to prevent current or future problems. In 2003, the 10 year Treasury bond yield increased by one percent in a two month period. This resulted in an 8.2% loss in that two months. During a 13 month period beginning in October 1993, 10 year Treasuries rose 2.4%, which resulted in a 10.6% loss for investors of these bonds.

On Friday, the 10 year Treasury yielded 2.746%. When the economy improves, and if yields rise to 4%, bond fund investors would lose approximately 7%, for that maturity. Holders of bond funds with maturities of 20-30 years could face losses of at least 10%. We feel the losses could be much more severe, as it is likely that investors will flee bond funds all at once, which would further exacerbate the losses, as funds are forced to sell securities en masse to meet redemptions.

The fixed income component of an investor’s asset allocation is critical to their investment success. To truly provide a client with comfort and security for the long term, given that interest rates are at all time lows and in the mid-long term will likely increase, we feel that investors would greatly benefit from holding individual fixed income investments, usually to maturity. This would prevent the losses described above.

See also post dated August 18, 2010, on the same topic.

Source: Wall Street Journal, 9/20/10, Treasurys Can Be Painful, as History Shows

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