Up to this point we've talked about bank deposits, money market mutual funds, fixed income products offered by insurers and other fixed income investments like convertible bonds and preferred stock. However, we haven't yet talked about investing in straight bonds.
Bonds are strange creatures. They appear to be safe, sound investments, but they can be risky if you don't know what you're doing. Although bonds are normally less volatile than stocks, the value of a bond investment can change dramatically, even if the issuer of the bond maintains an excellent credit rating.
This is because of the interest rate risk faced by bond investors. Interest rate risk is probably the biggest risk that bond investors face. If you had invested $1,000 in a new 30-year US Treasury bond in 1972, by 1981 that bond would have been worth only $500 if you tried to resell it in the open market.
The face value of the bond still would have been $1,000, and if you had held onto the bond another 21 years until maturity you would get the $1,000 face value back from the government.
So if the face value hadn't changed, why had the market value of the bond been cut in half? The issuer was still the US government, which has the highest credit rating of anyone in the United States. What's going on here?
The answer of course is that interest rates had skyrocketed since the bond was issued. When the bond was issued in 1972, it paid a coupon with a market interest rate of 7 percent. By 1981, however, inflation had pushed market interest rates for similar long-term US government bonds up to 14.5 percent.
Why pay the full face value of $1,000 for a bond paying 7 percent when other new bonds with a face value of $1,000 are paying 14.5 percent? Obviously, no one will pay full face value for a bond whose coupon payments are less than market interest rates.
So the price of the bond with the low interest rate is bid down until investors are indifferent between buying a new, full-priced bond paying 14.5 percent, or a discounted bond paying 7 percent.
This is the essence of interest rate risk. If interest rates go up, the value of your bond goes down. But it works both ways. If interest rates go down, the value of your bond goes up, offering you a chance for capital gains in addition to the interest earnings on your bond.
Interest rates are affected by many factors including Federal Reserve policy and foreign exchange considerations, but the largest factor affecting long-term interest rates is the expected inflation rate. An increase in the inflation rate gives a proportionate increase in long-term interest rates.