Are Bonds and Bond Funds Safe Investments in a Rising Interest Rate Economy?

Let’s say you’re on the conservative side and decide that bonds appeal to you. You won’t live forever, so a long-term bond is out of the question. You can choose from US Treasuries, Companies, and various mutual funds. It is tedious to follow individual bond prices and most people tend to trust a recommendation from their broker. Regardless of the method in which you arrive at a specific bond investment, many people feel secure and content in the knowledge that their interest and principal are guaranteed.

That said, if you hold your investment to maturity, you will receive interest and a return on your principal. What if you need your money before your bond expires? Can you 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 bought your bond.

If the rates have increased since you bought the bond, you will receive less than what you initially invested. If interest rates have dropped, you will receive more than your initial investment. There is an inverse relationship between bond yields and bond prices. When rates go up, your voucher is worth less. If interest rates drop, you will receive more than your initial investment.

Bond funds are also susceptible to fluctuations in principal prices, and the same is true for investors with individual bonds. It stands to reason that longer-term bonds tend to be the most volatile, as there is no way to determine what rate fluctuations may occur over a 30-year period of time. As maturities get shorter, there are less rate fluctuations.

I should also note that junk bond valuations are most often a function of the underlying guarantor of the instrument, as opposed to rate fluctuations, although they are also susceptible to rate fluctuations. Junk bonds tend not to fluctuate in price at high-grade corporate rates, as they are often priced and traded based 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 the basis points of loss for every 1% increase in current yield. Let’s say you are in a bond fund that has an average maturity of 5.4 years. So if the returns on a market bond go up 1%, your bond will decline 5.4%, in theory. It does not always work perfectly, but it is a very good method of estimating the profit potential when investing in bonds.

Obviously, bond funds perform well in a time when interest rates fall and underperform when rates are low, as they have little room to fall.

In short, I have said that bonds are risk-free if you hold them to maturity. However, if you need to liquidate your investment before maturity, you will be able to get more or less than your original investment. Rising interest rates cause bond prices to fall and falling interest rates cause bonds to appreciate. This is also true for bond funds.