Body text: It's a sad fact that some consumers do stupid things when they are scared. They sell low and buy high. They abandon the stock market altogether and park all their cash in savings accounts. Or they load up on bonds.
A lot of people think bonds are a safe, quiet place to ride out investment turmoil. But if in this flight to safety you've loaded up your portfolio with a bunch of bonds (regardless of whether they are government, municipal or corporate), I'm worried for you.
Bonds are subject to two prominent risks that can expose investors to substantial losses. If you own bonds or are thinking about buying them, be aware of these risks.
The first is interest-rate risk. Interest rates and bond prices have an inverse relationship: When one rises, the other falls. This is not conjecture; it's mathematical fact.
In normal times investors debate whether interest rates will rise or fall. But these days there is no debate, because the Federal Reserve has set its interest-rate target at zero. Rates cannot go into negative territory, so they only have one direction to go: up.
It may take months or even years for that to happen, but eventually rates will rise. When that happens, bond values will drop.
Why? You can thank the simple law of supply and demand. Say the government issues a 1 percent bond and you buy it. Later, say that the government raises rates to 2 percent and you decide to sell your bond. Would an investor rather buy your 1 percent bond or a new one that pays 2 percent?
Clearly, the 2 percent bond is the better choice. In order to find a buyer for your bond, then, you'll have to offer a higher interest rate. Oops -- you can't do that! You can lower your price, though. By selling the bond for less than its face value, the buyer is compensated for your bond's lower interest rate.
How much lower? Let's look at the math. Say you buy a $10,000, 10-year AAA-rated bond paying 3.9 percent. If rates rise 1 percent and you try to sell your bond, you'd lose 7 percent ($700) of your money. If interest rates go up 2 percent, you lose 14 percent, or $1,400.
Interest-rate risk isn't the only risk. There's also credit risk.
As companies experience financial difficulties, their bond ratings get downgraded.
If an AAA bond falls to AA, the bond's value drops 8 percent.