Bank CD rates are at historical lows and as a result the incomes of many retirees have also plummeted to new lows. Retirees that have historically kept retirement money in the stock market have been rocked by violent feast-to-famine cycles. With the stock market roughly halfway between its last peak and trough, there is widespread fear about the future direction. Many risk-averse safety conscious retirees have found a compromise in bonds: fixed rates like bank CDs, but less volatility than the stock market. Could it be that danger also lurks here? Let’s look at how bonds really work.
Businesses and governments borrow money by issuing bonds. These bonds are a promise to repay lenders at maturity and a fixed rate of interest in the meantime. Bonds can be backed by collateral or they can be an unsecured obligation of the borrower. The future year when the principal is repaid is referred to as “maturity” and the fixed interest rate paid is called the “coupon”. Of course, there can be other complexities (calls, conversion rights, etc.) but these are beyond our present scope. A bond generally has market liquidity, meaning it can be sold prior to maturity. A major determinate of the value of an existing bond is the difference in the coupon rate and the market rate of comparable bonds. It is this relationship between price and coupon/market rate that needs to be understood.
Let’s say you purchased a ten-year $1,000 bond and the coupon rate is 4%. Parenthetically, purchasing bond mutual funds is one very popular way to generate an income and also get diversification. Fast forward two years when your bond’s maturity is eight years hence and the market rate for a comparable bond is 10%. Assume you need money and you’ve decided to sell your bond. Your bond will be worth about $625 because its coupon rate is 6% below the market rate of comparable bonds. The longer the maturity of a bond, the more prices change as interest rates fluctuate. Bond prices rise and fall with interest rates and this is the risk of owning bonds.
The Federal Reserve, the government agency that manages monetary policy, has forced market interest rates to historical lows in hopes of raising economic activity and returning people to work. They do this by “buying” government bonds with newly created money: demand for bonds increase and their prices rise [rates fall]. In theory, lower rates stimulate borrowing which expands businesses, fosters new construction and prompts people to buy more goods and services. Heightened economic activity is the result. What happens if the economy strengthens and the Federal Reserve sells bonds to push rates higher to control economic activity? The holders of lower rate bonds will (a) realize a loss if they sell or (b) earn below market interest rates until maturity if they hold. Either way a monetary loss is realized. Since the Federal Reserve is also selling, what about their losses? They manage the monetary affairs of the economy and don’t consider profit or loss.
Generally, interest rates and inflation move in lockstep over an economic cycle. There is an emerging consensus opinion that huge federal deficits, the flood of new money created by the Federal Reserve and the deteriorating U.S. currency will fuel future inflation as the economy recovers. Accordingly, locking in fixed rate long-term bonds involves risks that must be considered. My advice is to work with your financial advisor to select suitable savings and investment places to provide the lifestyle you have planned for your retirement. So, instead of blindly following the herd to the new Mecca of bonds please make sure you understand them first.
Shelby J. Smith, Ph.D.
November 2010
Its extremely unfortunate that people who have spent their entire lives working towards a nice healthy and safe retirement have to lose their funds from the recent economic downturn.