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The safest investment in the world is U.S. Treasury bonds. The reason is simple: Uncle Sam can’t default on his obligations, because if necessary he can print the money to meet them.
Ironically, however, you can rack up serious losses in all kinds of bonds, including the world’s safest. Which brings us to this week’s reader question.
I’ve put a bunch of money into TIPS in the last two years in my 401(k). I got a statement from Vanguard that shows I’ve lost $6,000 in value in the last year. Or at least I think that’s what the statement means. Will I recover the value? How does that happen? I don’t get it. — Karen
This reader owns a fund that invests in a type of U.S. Treasury bond known as TIPS, something I’ll explain shortly. But if you own any kind of bond mutual fund, you really need to understand how they work and the potential for risk.
We’ll start with a quick explanation of TIPS, then move on to other types of bonds.
How do TIPS work?
TIPS is short for Treasury Inflation-Protected Securities. The idea behind them is simple: When you invest in TIPS, not only does Uncle Sam guarantee you’ll get your money back, he offers protection against inflation.
From the Treasury’s TIPS page:
Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.
And TIPS should be safe. From Investopedia:
TIPS are considered an extremely low-risk investment since they are backed by the U.S. government and since their par value rises with inflation, as measured by the Consumer Price Index, while their interest rate remains fixed.
The bottom line: If you buy TIPS at par (face) value, you shouldn’t be able to lose money. So how could our reader have lost value? To understand that, you need to understand the following.
How bonds work
While it may seem there are tons of different types of investments, the vast majority fall into just two categories:
- Loaner. You lend money to someone and they promise to pay it back at some future date, along with some interest. Loaner investments include certificates of deposit and all types of bonds.
- Owner. You own part of a company, typically in the form of stock. There’s no set interest rate, no maturity date and no guarantee you’ll get your money back.
Both types of investments have two distinct kinds of risk:
- Default risk. The company or issuer of the security goes bankrupt.
- Market risk. The risk is that the market value of the security declines.
As I said above, U.S. Treasury bonds have virtually no default risk, because the government can print money. But from the time they’re issued until the day they mature (which could be as long as 30 years) treasuries, along with every other type of bond, can fluctuate in value.
And sure enough, the Vanguard TIPS mutual fund, as I write this, has dropped in value by nearly 7 percent over the last 12 months.
What makes bonds go down in value?
If you’re willing to wait until U.S. Treasury bonds mature, you’ll always get the face amount. But as I said, between now and then, prices can change. To understand how, imagine a seesaw.
On one end of the seesaw are bond prices. On the other are interest rates. If interest rates rise, bond prices fall. If rates fall, bond prices rise.
To put it a bit more technically, bond prices are inversely related to interest rates.
Why is this? Well, imagine last year I put $1,000 into a 10-year Treasury bond with an interest rate of 1 percent. But today interest rates have risen and now identical 10-year bonds are being issued with a rate of 2 percent. Since anyone would rather earn 2 percent than 1 percent, if I wanted to sell my bond today, I’d have to sell it at a discount. Interest rates went up and my bond’s value went down.
Remember, it’s still going to be worth $1,000 when it matures. But today? Nope. Something else to know: The longer it is until the bond matures, the more it will drop in value if rates rise.
Now let’s go from classroom to the real world. I came across a quote in Kiplinger from one of the managers of Karen’s TIPS fund. It’s perfect to put this lesson in perspective:
When rates rise, TIPS prices will fall. … If rates rise one percentage point, the typical TIPS mutual fund will lose about 6 percent of its value. “Investors need to understand that they are buying inherently volatile vehicles,” says Gemma Wright-Casparius, co-manager of Vanguard Inflation-Protected Securities.
If the value of my fund drops, will it come back?
Karen is rightfully concerned that her TIPS fund has decreased in value by $6,000. But shouldn’t that decline be temporary? After all, I just explained that while bonds may fluctuate in value, they should mature at face value. That means any losses showing on her statement between now and then are only temporary.
Or are they?
It’s true that if you hold a single bond until it matures, you should get your principal back. But a bond mutual fund isn’t a single bond. It’s a vast portfolio of bonds, with a manager who’s likely buying and selling. Whenever a bond within that portfolio is bought or sold, it could be at a profit or loss.
So while a TIPS fund like Karen’s removes the default risk, a manager who’s buying and selling bonds is still taking market risk. And that market risk could translate into real, as opposed to paper, profits or losses.
And you now know what’s behind most losses in the bond market — rising interest rates.
These could be the most important words you read this year
When the stock market was cut in half back in 2008-2009, it ruined lives. People lost jobs. 401(k)’s were decimated. Many on the verge of retirement were forced to stay in the workplace to make up their losses.
And many of those afraid of stocks probably turned to bonds, assuming they’re a safer alternative. They’re right, but only as long as interest rates don’t rise.
Despite a slight rise over the last year, rates are still at historic lows. A lot of investors in long-term bond mutual funds will be caught flat-footed when and if rates start rising in earnest.
What’s an investor to do?
Unless you’ve got a crystal ball, the best thing to invest in is everything. Some stocks, some short-term bonds, some long-term bonds, some money market funds. Few people can time the stock market and few can time interest rates, so spreading your investments around is always a good idea.
I don’t expect interest rates to rise violently or soon. But when they do move, I expect them to move up. It’s not rocket science: Rates are historically low, and really have no place to go but up.
As I said, the longer it is until a bond matures, the more it will respond to rising or falling rates. Since I’m concerned about rising rates, I’d be in shorter-term bonds or bond mutual funds. They won’t pay as much in interest, but if rates rise rapidly, they’re a lot more likely to preserve principal.
As Mark Twain famously said, “I’m more concerned with the return of my money than the return on my money.”
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