"What is Interest Rate Risk?"
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The number one factor which affects the price of bonds is interest rates.
The Interest Rate of a Bond is Its Yield
There are many bonds available for sale. New bonds are issued every year at the interest rates prevailing at that time.
Since bonds can typically last for 20 years, unless they're called, and there're even some 100 year bonds which you can buy you can buy bonds that're 10 or 15 years old if you want. But obviously they will have different interest rates than bonds do today.
In the overall economy, interest rates are always fluctuating up and down.
Bond Issues Pay Different Interest Rates
If you're going to put down $1000 for a bond, would you rather get one that pays 4% or 5%?
Obviously, you'd rather get the 5%.
So if the prevailing interest rates for bonds today is 5% -- then what happens to the price of bonds which are paying only 4%?
The price goes down.
Bond With Different Interest Rates Have Different Yields
So you can pay 100% for a bond that pays an interest rate of 5% -- for a 5% yield or --
You can pay 80% for a bond that pays an interest rate of 4% -- for a 5% yield.
To the buyer, both choices are equivalent.
However, what if you're the owner of the bond paying only 4%?
You bought the bond a year ago for $1000. Now it's worth only $800.
Bond Prices Can and Do Fluctuate
They don't generally go up or down as far or as fast as stock can, but they sure don't stay the same.
You can lose money by buying bonds before interest rates go up.
A lot of bond buyers don't understand that.
The Only Real Protection is to Buy Separate Bonds and Hold Them Until Maturity
In the example above, you will get your full $1000 back after the end of the 20 year period.
However, you should not be buying individual bonds. You need to diversify with a noload mutual bond fund. And when you do, you will see fluctuations in the price of shares of the fund, as interest rates rise and fall.
I advise you not to care about the price of the bond fund shares. They will fluctuate.
When Interest Rates on Bonds Go down, So Will the Interest Your Bond Fund Pays You
That does affect your income from bonds.
The only way to protect yourself from that is to reinvest some of the interest so that you continually have more money in the fund.
That's the same advice I gave you to reduce the risk of inflation/loss of purchasing power.
And it works in both situations.
When Inflation is High, Interest Rates Tend to Go High
Your interest income is higher, but it doesn't buy any more, because prices are also rising.
When inflation is low, interest rates tend to be low. Your interest income is low, but it retains greater purchasing power.
So if you keep reinvesting some of your interest income, you continually expand your base so that in times of high inflation your interest income will grow at least that much. In times of low inflation, your interest income will not grow as much but will still keep up its purchasing power.
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