Ric Edelman: Today, we're talking about bonds and interest rate risk. Interest rates and bond prices have an inverse relationship, when one rises, the other falls. Think of a seesaw, one side goes up, the other side goes down. Now, in normal times investors debate about whether interest rates will rise or fall, but these days, there is no debate because interest rates are near zero.
So, most people have concluded that rates are destined to eventually go back up. Of course no one knows when that might happen, it could take months, even years, but eventually it's reasonable to assume that rates will rise. And when that happens, bonds values will fall. Why? Well, you can find the simple law of supply and demand. Say the government issues a 1% bond and you buy it. Later, say that the government raise its rates to 2% and you decide to sell your bond. Well, would an investor rather buy your bond at 1% or the new one that pays 2%? Clearly, the 2% bond would be the better choice.
So in order to find a buyer for your bond, you would have to lower your price. How much lower? Well, it's based on a calculation called duration, and you could lose as much as 7% for every 1 point increase in interest rates. That's for a bond with a 7-year duration. So if interest rates go up 3%, that bond's value could fall by 21%. So you see bonds aren't quite as safe as you may have thought.