My Words Are Your Bonds: But Should You Keep Buying Them?

BY Paul Solman  December 6, 2012 at 11:23 AM EST


There are some sobering realities to consider when betting on bonds. Photo by Cultura/Liam Norris via Getty Images.

Paul Solman answers questions from the NewsHour audience on business and economic news here on his Making Sen$e page. Here is Thursday’s query:

Maura Walsh: How safe are bond funds for retirees?

Paul Solman: Not so safe. The question remains: what’s safer?

Making Sense

Peter Richman: Since TIPS (Treasury Inflation-Protected Securities) have a high correlation to the bond market, aren’t you afraid of rising interest rates?

Paul Solman: You bet I am, as I’ve made explicit time and again, most recently here.

For those who don’t understand the question, TIPS are bonds issued by the federal government in return for money it borrows. Their interest rate is pegged to inflation in that the rate includes a Consumer Price Index adjustment. The problem is, TIPS have become so popular as a hedge (protection) against inflation, customers now pay a premium to own them. A $1000 Treasury Inflation-Protected Security that matures — pays back the principle — in 20 years now costs you more than $1000. The effective interest rate is published daily at the online Wall St. Journal and works out to about -.10 percent at the moment. That’s 10 “basis points” – ten hundredths of a percent. For simplicity’s sake, let’s say inflation will run at 2 percent for the next few years. Then TIPS will pay 2 percent minus .10 percent: 1.9 percent in all.

And now at last the explanation of my answer to the original question. I’m scared because if interest rates suddenly rise tomorrow, TIPS may have to pay more than 1.9 percent to find buyers. Why purchase a bond paying 1.9 percent when there’s a new one, issued by the government, that pays more?

In other words, the TIPS I’m currently holding would suddenly be worth less. That’s the danger of holding any bond: that interest rates will rise, causing new bonds to carry a higher interest rate than the old ones you’ve got. Thus the old ones, paying a less attractive rate of interest, lose value. And that is why when interest rates go up, bond prices go down — and vice versa.

This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions