In 2007, certain risky financial instruments, such as credit default swaps, began to collapse in value. Within months, major Wall Street firms and commercial banks began to fail in what analysts called "a crisis of liquidity." Banks sharply reduced lending. The U.S. housing market, until then supported by credit default swaps and other derivative financial instruments, nearly collapsed. The Dow Jones industrial average, a conservative barometer of U.S. stock values, plunged from a high of 14,164 to 6,547, a loss of more than half. Beginning with this crisis, retail investors, increasingly fearful of the stock market, have relied increasingly on bonds as safer financial instruments with a guaranteed return. However, bonds have their own risks, which investors may not fully realize.
When you buy a bond, a ten-year U.S. Treasury Note, for example, you have a return guaranteed by the U.S. government. On September 8, 2010, that rate equaled 3.42 percent annually. However, the bond also has a resale value, and that value changes inversely with the current interest rate. Due to unprecedented worldwide conditions related to the financial crisis that began in 2007, interest rates have declined to a low not equaled since March, 1957.
Declines in Value
Significantly, for over 90 percent of the time between March, 1957 until now, bond rates have exceeded the current 3.42 percent. If past performance has any meaning at all, it suggests that bond rates will rise significantly as world confidence in financial markets returns and that bond resale values will fall. Investors who own bonds purchased within the last couple of years will lose a substantial amount of money unless they keep these bonds to maturity.
Initially, you may think that the scenario where you can only get the promised rate of return on a bond by holding it to maturity represents a danger more theoretical than real, that if you do hold the bond to maturity you have not suffered a real loss. Unfortunately, you have. To understand this, let us consider why interest rates rise and fall generally. In a time of deflation, interest rates can fall past zero. In times of inflation, interest rates rise. If you have a low-interest-rate bond and can only get back what you paid for it by holding it to maturity, and meanwhile the economy has become inflationary and interest rates have risen, the purchasing power of the dollars in your bond declines by after day. You can only get out of the bond by selling it at a substantial loss.