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Why bonds lose value when interest rates rise

(MoneyWatch) I'm often asked why there is an inverse relationship between interest rates and the price of bonds and bond funds. This means bonds do well when rates decline and, as occurred in May, lose value when rates go up.

The way I explain it is to imagine you loan me $100 at 5 percent for 10 years, which we will assume is the market rate. I'm going to pay you $5 a year for 10 years and then give you the $100 back in a decade. Now imagine that right after you lend me this money, the Federal Reserve changes its policy and the U.S. stops buying back our own bonds. Immediately, rates shoot up, and suddenly a rate of seven percent is the going market rate to lend money to me.

Though you will still be collecting $5 a year from me for 10 years, that's $2 less than the going market rate. The loan of $100 is no longer yielding the market rate. To be more precise, it's now worth $85.95, a decline of $14.05. 

The same thing happens to bonds and bond funds. Note that holding the bond until maturity and collecting a below-market interest rate in no way protects you against rising rates. Thus, bonds and bond funds are just as risky.

How to protect yourself

Economists have been guaranteeing higher interest rates for many years, even as rates continued to decline. Still, rates can't turn negative (since you are not likely to lend me $100 with the promise to pay back $99 next year).

That's why I like CDs with easy early-withdrawal penalties. Rather than collect a below-market interest rate for years, simply pay the easy early-withdrawal penalty and reinvest at that higher rate.

As of late May, the Vanguard Total Bond Index (VBMFX) is yielding 1.45 percent and would decline by about 5.3 percent should rates increase by one percent. The Ally Bank five year CD is yielding 1.54 percent, and the 60-day penalty amounts to only about 0.26 percent. In this way, you get a higher yield and less risk (staying below the FDIC insurance limits, of course).

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