After 30+ years of a bull market in bonds, we are now at or near historically low interest rate levels. That’s also meant an increase in bond prices over the last 30 years. The most likely future outcomes will mean an increase in interest rates and a commensurate falling of bond prices.
Picture a teeter-totter. On one end are interest rates. On the other end is the price of the bond. When one end goes up, the other end goes down. If interest rates go up, bond values go down. It’s been the other way around for the past thirty years, interest rates have gone down, therefore bond prices have gone up. The key question from here isn’t which direction but “how much?”
If you own bond mutual funds there is a key risk component you need to understand, and that is the term “duration”. I’ve found it easiest to obtain by going to the website for the fund family and then looking at the specific fund fact sheet. You’re looking either “modified duration” of “effective duration” and there will be a number given, say 4.2, and it’s shown in years.
What the 4.2 years means is that if long-term interest rates go up by 1%, your bond fund with a duration of 4.2 will go down by approximately 4.2%. If your duration was 6.8 years, your bond fund would lose about 6.8% for the same 1% rise in interest rates. A 2% rise in interest rates would double the loss of either of these funds, 8.4% and 13.6%. That’s a virtual certainty of loss of principal value.
So, if you’ve been told that bond funds are “safer” you really need to find out the duration numbers for you funds, and have a plan to deal with rising interest rates. Almost everything I read in our industry press suggests simply shortening the duration of the bond funds, and while that will lessen the damage to some degree, all it really does is provide a smaller loss.
Has your current advisor talked about this with you? Would you perhaps do something different now that you know about this? Why do you suppose this information wasn’t shared with you?
Interest rates are going up. Have a plan. We have a plan.