Ric Edelman: Interest rates and bond prices have an inverse relationship when one rises, the other falls. Think of a see-saw, one side goes up, the other side goes down.
Now in normal time 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, bond values will fall.
Why? Well you can thank the simple law of supply and demand. Say the government issues a 1% bond and you buy it. Later, say that the government raises 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 paced 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 one point increase in interest rates. That's for a bond with a seven year duration. So if interest rates go up 3%, that bonds value could fall by 21%. So you see bonds aren't quite as safe as you may have thought.
Almost all bonds have a credit rating; this rating estimates the safety of the bonds. Will you get the interest you are promised, will you get your money back at maturity? The credit rating helps you know how safe your bond is. Naturally investors are willing to pay more for bonds with high ratings and less for bonds with low ratings, but bond ratings can change, say if a company or state government gets into financial trouble. And if that happens, the bonds they have already issued, the bonds you have already bought could get downgraded.
And if they get downgraded you could loss 10, 20 even 30% or more from your bonds value. And if interest rates rise 3% on a seven year duration bond while this is happening, your total losses could be 30, 40, even 50%.
I have been warning you about interest rate risk and credit risk when investing in bonds. Now, I'll show you how you can reduce your exposures to these risks. First, pay attention to the bonds duration.
Duration refers to the average life of the bond. That's usually shorter then the maturity date. Long term bonds are more sensitive to rising interest rates than short term bonds, so you can cut your interest rate risk by only owning bonds that have durations or maturities of seven years or less. The shorter the duration, the lower the risk to rising interest rates.
Second, only buy bonds that are unlikely to experience cuts in their credit rating. That means you should focus on bonds that are issued and backed by the federal government. Those without are not as immune to credit risk as those issued by Uncle Sam.
Third, don't overweight your portfolio with bonds. Maintain diversification, on not just bonds but also stocks, real estate, precious metals, oil and gas, assets that are not directly affected by changes in interest rates or credit ratings.
Diversification helps when facing the challenges of the financial market place in turmoil.