Bonds, especially US Government bonds, are often mistakenly considered super safe. But even though the bond principal and coupon interest is fully guaranteed by the federal treasury bonds, like stocks, have market risk and are subject to price fluctuations.

For example, consider a $1,000 bond issued by some arm of the federal government that pays a $50 a year in stated interest (5%). If four years after issue, interest rates have risen to10%, the bond still pays $50 a year. However, new $1,000 bonds are paying $100 (10%). No one will spend $1,000 for a bond paying $50, if they can buy one paying $100 for the same price. To be competitive, our $50 bond has to adjust its price and could reasonably expect to sell for only $500 ($50 / 10%). Wow our nice safe government guaranteed bond lost 50%. Note the federal government only guarantees the principal at the bonds maturity. The guarantee is of little assistance at the points in between issue and maturity. Of course we could hold the bond for another twenty-four years and collect the $1,000 in principal. If we did that we would be collecting only $50 a year in interest. Everyone that bought a new bond would be collecting $100. In either scenario, interest rate fluctuations have devalued our bond.

[Actually the price of our bond will not be exactly $500. Because it is redeemable in 24 years, the additional $500 that will eventually be collected must be discounted and included in the price. Therefore, the true yield will be the $500 in principal, discounted for 24 years at the market rate of 10%, plus the $50 collected each year in coupon interest. A 10% discount for 24 years calculates to about 10 cents on the dollar, so the $500 in principal would be worth around $50 if collected today. The actual price of the bond would therefore be around $550.] However, our point is not to get bogged down in investment math, but to demonstrate that even a federally guaranteed bond is subject to market forces that generate systemic risk.

The price of bonds, both industrial and governmental, will rise or fall with each change in interest rates. The wider the interest rate swing the greater the impact on the value of the bond. Also, the longer the maturing of the bond (the date the principal is due) the greater the fluctuation in the price for any given interest rate change.

Managed Bond Portfolios

Bonds are often held in a managed account, in which a professional manager selects the quality and the maturing of the bonds to meet a specific investment objective. A managed portfolio can be either active or passive. An active portfolio is continously managed. In a passive portfolio, the bonds are initially selected to meet a given objective and thereafter the portfolio is self liquidating. As bonds mature, principal is distributed to the individual participants. Eventually, the last bond matures and the fund is totally liquidated.

The price action of individual bonds determines the price action of the overall portfolio. Short maturing bonds will react much less to interest rate changes than will 20, 30 and 50 year bonds. The weighted average maturity of the portfolio will control how much the value of the portfolio will react to changes in interest rates.

Note: The information provided above is for informational purposes only. It is not intended as a recommendation to either use bonds or not use bonds as an investment media. Its sole purpose is to acquaint the reader with the fact that the purchase of long term bonds entails that assumptions of market risk.