Bonds lose appeal as interest rates move higher

ON THE MONEY

Your Money

November 20, 2005|By GAIL MARKSJARVIS

If you think bond mutual funds are supposed to keep your savings safe, you might not like what you see when you examine your next statement.

The past few months have been rough on bonds. Interest rates have been rising, and when that happens investors in bond funds can lose money, even in the safest of bonds.

During the past three months, funds that invest in U.S. government bonds lost 1.17 percent on average, according to Lipper Inc., which tracks mutual fund performance. Funds that invest in high-quality corporate bonds lost 0.73 percent, and riskier high-yield bond funds were down 1.23 percent.

Losses have been occurring because interest rates have been climbing amid concern about inflation. The trend is expected to continue into next year, although even the most knowledgeable bond experts say that predicting interest rate movements can be folly.

When interest rates rise, bonds lose value because investors can find better-paying bonds. Think of it this way: Imagine you buy a $1,000 bond that pays 4 percent interest, or $40 a year. But a few months after you have bought it, interest rates have risen, and people can buy similar bonds that pay 6 percent interest, or $60 a year.

At that point, investors wouldn't want your 4 percent bond, so it would drop in value.

Investors who buy individual bonds and hold them until they mature don't have to worry about losses. They will get all the interest payments they were promised, and their original investment, or principal, will be returned too.

But funds buy many bonds, and if the money is tied up in low-interest bonds when new higher-interest bonds become available, the value of the fund falls. That even applies to funds that invest in Treasury inflation-protected securities (TIPS), or bonds that are adjusted higher when inflation is increasing. Last month, the average TIPS fund lost 1.34 percent.

If you need to pull money out of a bond fund when the value is down, you will lose money. There is no maturity date for bond funds, no date when you can count on retrieving what you originally invested.

So if you are retired and need to take money out of a bond fund at a time when interest rates are climbing, you may incur a loss. If you are a parent, pulling cash from a 529 college savings plan to pay for tuition, you might have to take money out of a shrinking cache.

Consequently, in an environment like the present one, when strategists are expecting somewhat higher interest rates, investors need to be cautious if they will need money soon.

Colin Robertson, managing director of fixed income for Northern Trust, thinks the Federal Reserve is about done raising interest rates and that the yield on 10-year Treasury notes isn't likely to go above 4.75 percent in the next few months. It's currently at about 4.5 percent.

Robertson said retirees who need cash within six months should consider the safety of a money-market fund or six-month CD rather than a bond fund.

Parents with college savings in bond funds also should be cautious if they have children attending college or are within a year of starting college. Typically, 529 college savings plans put significant amounts of savings into bond funds as students approach their college years. If the money is in short-term bond funds, or funds that invest in bonds that will mature within a couple of years, it will be safer than if bonds won't mature for five or more years.

gmarksjarvis@tribune.com

Readers may leave messages for Gail MarksJarvis at 312-222-4264.

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