As we remind SMI readers from time to time, when interest rates go up, bond values go down. This applies even to super-safe investments such as U.S. Treasuries.
Since we've had falling rates in the U.S. during most of 2010-2011, this has not been evident of late. But if the economy eventually picks up, rates will begin rising. Incidentally, this can happen even if the Federal Reserve holds short-term interest rates steady. While Fed policy dictates rates at the short-term end of the yield curve, longer-term interest rates are determined by supply and demand in the bond market.
The table below shows the losses incurred by U.S. Treasuries of various maturities during 2009, a year characterized by rising interest rates. As you can see, the longer until maturity, the greater the loss when rates rise. The longest-term bonds, which enjoyed the greatest gains while rates were falling, likewise suffered the greatest losses once the interest-rate pendulum began to swing in the other direction — losing 28.5% in value for the year.
Of course, if you buy a Treasury security (or any other bond) and hold it until it matures, you can ignore market fluctuations. When the maturity date arrives, the government will pay you the $1,000 face value regardless of how much the bond may have moved up or down in market value in the meanwhile. But anytime you sell a bond before its maturity date, it could be worth less than you paid for it if interest rates have gone up since you bought it. Long-term savers can reduce the risk of rising interest rates by building a bond "ladder" of staggered maturities.
If you invest in bonds through a mutual fund rather than buying individual bonds, you have a different risk. The portfolio manager is constantly buying and selling bonds with many different maturities. The fund has an "average" maturity, but not a single date when all the bonds in the portfolio will mature together. When some of the bonds in the portfolio do mature, the money is reinvested in more bonds. As a result, a bond fund never reaches maturity. That means there's no future date when you're guaranteed to receive a certain amount. You can't necessarily count on recouping any losses in value just by holding your shares long enough.
The good news is that savers can largely neutralize this risk by doing two things. First, stay with short maturities — shop among the bond funds in Bond Risk Category 1, concentrating on the ones with the lowest "relative risk" scores. Second, determine to hold your short-term bond funds at least two years. In the past 20 years, it has been extremely rare for investors to lose money in short-term corporate or government bond funds when they maintained their holdings at least two years. The average result saw annual gains of 4.2%-to-4.4%, and the worst results ranged from a loss of -0.9% to a gain of 0.8%.
So keep an eye on those maturities, and remember, the sooner the bond matures, the safer you are.