As the saying goes, better late than never.
FINRA is certainly not the first to warn investors about today’s risks to the bond market (I’ve been talking about it for a while now). Nonetheless, a couple of weeks ago an investor alert was issued. And it’s a warning worth heeding.
According to FINRA: “If you own bonds or have money in a bond fund, there is a number you should know. It’s called duration”. Duration is stated in years, but it is a measure of more than length of time. Duration gives you an idea of how much a bond might fluctuate with changes in prevailing interest rates.
The higher the duration, the more sensitive a bond is to movements in rates.
Bond investors need to keep in mind that bond prices and interest rates have an inverse relationship: when the prevailing interest rates go up, bond prices go down. This is known as interest rate risk.
Interest rate risk means bond prices are affected by rate changes. And duration risk signals how much they can be affected. FINRA’s example: if interest rates increase 2%, a higher duration bond (a 30-year maturity and a 4.5% coupon) could lose as much as 15% of its value. The same goes for bond funds: a bond fund with a 10-year duration could lose 10% of its value if interest rates go up by 1%. Given that interest rates have been lingering near historic lows – and can’t go much lower – this is something bond investors need to think about.
And even if a bond has a low duration, there are still other risks: call risk, default risk, inflation risk.
The thing to remember is that while most investors consider bonds to be relatively safe, there is still a chance to lose money.