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Bond Prices Fall When Interest Rates Rise
When analyzing what 2010 may look like for the bond market, nothing looms bigger than interest rates. Bond prices are affected by supply and demand, just like all securities. However, a key element of demand for fixed income securities such as bonds is the prevailing interest rates.
An example is helpful to illustrate just how big of effect interest rates have on bond prices.
Let's say that someone wants to borrow money from you for 5 years. You are willing to lend the money as long as the borrower pays at least as much interest as you would earn on a 5 year CD. For example purposes, lets' say that the current interest rate for a 5-year CD is 5.0% per year. Thus, you would be willing to lend money as long as the borrower pays at least 5%.
Assume that interest rates rise over the next year such that a 5-year CD is now paying 6% interest instead of 5%. How much would you want now in order to lend someone money? You would now require 6%. So would any other investor. That means that if you wanted to sell your IOU (or bond) to someone else, they would only be willing to buy it if it paid 6%. But since your note only pays 5%, how can it be sold?
The answer is by lowering the price.
For example, if the original loan was for $1,000 at 5%, then in order for an investment in that note to yield 6% you have to pay less for it. How much exactly depends upon when the bond is sold and how much time is left before repayment, but no matter what, the amount is less.
For bond holders who intend to hold the bond until it matures and then redeem it for full value, this is of little consequence. However, for bond investors who need to sell, or more commonly, for investors in bond mutual funds, this drop in value is unavoidable.
As 2010 begins, interest rates are at all time lows. When interest rates rise, the value of fixed income securities decline. Exactly when in 2010, the Fed will begin raising interest rates isn't known, but when they do rise, the prices of bond funds and other fixed income funds will fall.
Consider shifting a portion of your investment dollars from bond-type funds into income funds that generate dividends from equities instead. For long-term investors, like retirement investors with 10+ years to retirement, such shifts should be small. Perhaps lightening the overall allocation to bonds by 5% for some investors may be prudent.