The headlong rush into bonds continued in 2012 despite 10-year Treasury yields below 2 percent, their lowest level since George Washington was president.
And yet, according to new research, "At today's ultra-low yields, bonds are not just a poor source of income, they are also less likely to preserve capital," writes Seth Masters, chief investment officer of Bernstein Global Wealth Management, a unit of AllianceBernstein L.P.
What investors need to appreciate is this mathematical fact: When interest rates do start rising, the prices of many of the bonds in our portfolios are going to drop. "Yields have almost nowhere to go but up, which would push bond values down," writes Masters in a new study called "Desperately Seeking Safety."
Because interest rates have been coming down since roughly 1982, with intermittent increases by the Federal Reserve in some years, a whole generation of investors has become accustomed to bond prices increasing over the long term.
Not so any longer. Bond prices trade up and down based on a few factors: interest rates, when the bond matures, whether you hold the bond until then or sell it before maturity, and demand for it in the marketplace.
What happens when interest rates go up? This is where the concept of "duration" enters into play.
If you own bonds or have money in a bond fund, duration is a term you should get to know.
Although stated in years, duration is not simply a measure of time. Instead, duration signals how much the price of your bond is likely to fluctuate when there is an up-or-down move in interest rates. The higher the duration number, the more sensitive your bond investment will be to changes in interest rates.
Currently, interest rates are at historic lows. Many believe that interest rates are not likely to get much lower and will eventually rise. If so, then bonds with a low interest rate and high "duration" today may be hurt in price as interest rates rise in the future.
If you have money in a bond fund that holds primarily long-term bonds, expect the value of that fund to decline, perhaps significantly, when interest rates rise.
Here is an excerpt from a recent piece from Financial Industry Regulatory Authority Inc. (FINRA): "Many factors impact bond prices, one of which is interest rates. A maxim of bond investing is that when interest rates rise, bond prices fall, and vice versa. This is known as interest rate risk. But just as some people's skin is more sensitive to sun than others, some bonds are more sensitive to interest rate changes. Duration risk is the name economists give to the risk associated with the sensitivity of a bond's price to a 1 percent change in interest rates."
The higher a bond's duration, the greater its sensitivity to interest rate changes. This means fluctuations in price, whether positive or negative, will be more pronounced.
For instance, if interest rates were to rise by 2 percent from today's low levels, a medium investment-grade corporate bond (BBB, Baa or similarly rated) with a duration of 8.4 (10-year maturity, 3.5 percent coupon) could lose 15 percent of its market value. (A coupon is the interest rate on a bond, usually paid semiannually.) A similar investment-grade bond with a duration of 14.5 (30-year maturity, 4.5 percent coupon) might experience a staggering loss in value of 26 percent.
The higher level of loss for the longer-term bond happens because its duration number is higher, making it react more dramatically to interest rate changes.
Duration has the same effect on bond funds. For example, a bond fund with 10-year duration will decrease in value by 10 percent if interest rates rise 1 percent.
On the other hand, the bond fund will increase in value by 10 percent if interest rates fall 1 percent. If a fund's duration is two years, then a 1 percent rise in interest rates will result in a 2 percent decline in the bond fund's value. A 2 percent increase in the bond fund's value would follow if interest rates fall 1 percent.
To find your bond fund's duration, look for it in the fund's fact sheet, often in the bond-holding statistics section.
Finding the duration of an individual bond can be a bit trickier. Start by asking your investment professional or the bond's issuer.
For a full discussion on owning bonds, visit FINRA's web site at: http://www.finra.org/Investors/InvestmentChoices/Bonds/SmartBondInvesting/Introduction.
Erin E. Arvedlund is a finance reporter and a Philadelphia resident. Contact her at firstname.lastname@example.org or 1-646-797-0759.