In case you haven’t been paying attention, the mainstream financial media has been all atwitter with talk of a bond bubble. With the recent (and not-so-recent) stock market turmoil that we’ve been dealing with, investors have been flocking to bonds.
The problem with this is that bond interest rates are at historically low levels, meaning that they really only have one way to move – up. And what happens when interest rates move up? That’s right. Bond prices decrease.
Think about it logically… If bonds were paying 3% and rates rose such that new issues were paying 5%, which would you want? The higher one. Thus, the old 3% version will sell at a discount.
If you hold your bonds to maturity, this is a non-issue. But if you: (a) want to sell them early, or (b) own bonds through a bond mutual fund, then you’re facing potential price fluctuations. And again… When rates rise, prices fall.
Of course, this is a bit of an oversimplification, as there are other factors that influence bond price changes. One of the biggest factors is the time to maturity.
In general, longer term bonds are associated with higher interest rates. The primary reason for this is that you are locking your money up for longer, and are taking on more interest rate risk.
Though longer term bonds offer more predictable interest rates, they are subject to much more pronounced price swings. This relationship is summed up very nicely by an interactive graphic that I recently discovered over at Vanguard.
I’ve included a screenshot below, but I highly recommend clicking through and playing with it – especially if you’re not very family with how the bond market works.
And now, a question…
Are we in the midst of a bond bubble? If so, how are you dealing with it?