Get the Hell out of Bonds
Long term bond prices are on the brink of collapse. With record high borrowing ahead in 2010 as well as indication from the Fed that it wants higher rates whilst promoting inflation, bond yields are set to soar while prices crumble.
How Bonds Work
Bond prices trade inversely to the interest rate. For instance, a bond selling for a face value of $1000 selling for $1000 at market at a 7% interest rate would yield 7%. However, for the interest rate to reach 7.7%, the market price of the bond would have to dip to $900. Those who invested at $1000 would be carrying a paper loss of $100, or about 1.4 year’s coupon. Of course, the full $1000 face value is repaid at maturity (whether you paid $5 or $1400 for it).
Short Term Losses on Long Term Bonds
As interest rates rise, long term bonds will be the most affected. Generally, short term bonds hold their price well because the maturity date is closer, and thus investors feel better about the fact their paper losses will be erased when the maturity date comes. Long term bonds, on the other hand, can sink for years. Literally, the last place on investing earth you would want to be is a 30 year Treasury when rates are set to rise. Even 10 year bonds can be hugely affected.
How Much it Hurts
The Wall Street Journal put together an interesting chart for investors who want to easily see the effects of rising interest rates on a 10 year bond. As rates rise, the value of the bond plummets, virtually locking in the buyer as no one wants to generate a loss out of what is at the time just paper losses.
