How can a bond gain 6% interest but lose on its principle?
OK, please read the column I recently posted: “Beware of Bonds.” OK, so you buy a Triple A rated, 30 year bond, paying 6 percent interest. (You won’t find that today– but that’s what you asked!) You pay $1,000 for the bond — and you know you will get 6 percent interest every year, AND get your $1,000 back at maturity in 30 years.
Now, along comes inflation, or the Fed tightens, and all rates rise. The same company/government, still AAA rated, needs to borrow more money. Only since all interest rates have risen, they must offer 8% to entice people to buy these new 30-year bonds. So people who hung on to their cash, now get a chance to get a much nicer return.
What happens to your bond. Nothing — you still get 6% but you’re a bit annoyed at being locked in to a lower rate. HOWEVER, if you wanted to sell your bond in the next few years, needed the money for an expense, then no one would give you $1,000 for your old 6% bond!!! (Remember, if they had cash, they could buy a new 8% bond.) So if you go to sell it in the bond market, you might get only about $800 for it!
So you say you won’t sell. But when you eventually get that $1,000 back it won’t be worth as much because of inflation — and your interest along the way won’t be enough to compensate for inflation!
When interest rates rise, bond PRICES go down! The longer the maturity, the bigger the price decline. This happens to ALL bonds, no matter what their rating. SO, if you think rates might rise, you don’t want to be locked up in 30 year bonds at today’s rates.
Do you think rates will rise?? The Fed is telling you they WILL!!