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.