“But can the market price of Treasury bonds go down too?” Gabriel asked. “Yes. They can go down because of the ‘need’ factor I told you about. And all bonds—whether Treasury or corporate—can go down for one other reason.” “What’s that?” “I call it the ‘envy factor.’ ” “Huh?” Linda interjected. “I understood the ‘need factor.’ Fear I also understood. But envy?”
“Let’s say I have put $100,000 into a U.S. Treasury bond that will pay me a fixed 5 percent per year for the next 30 years. How much do I collect in interest each year? The husband replied, “$5,000?” “Right. But now things change. Time goes by, and interest rates go up and up. The Treasury issues new bonds that pay a lot more now, say, 10 percent per year. What happens? I suffer from yield envy—I envy everyone who’s buying the new 10 percent bonds. I say to myself, ‘Darn, if I had only waited, if I had only bought the new bonds paying 10 percent, I could be earning $10,000 per year instead of just $5,000.’ ”
“Tough luck, eh?” interjected Gabriel. “You said it! So one day, I go to you like a used-car salesman and say, ‘Hey, I’ve got this great bond I bought not long ago. Check it out. It’s paying me a nice, respectable income of $5,000 per year, and it’s 100 percent guaranteed by the United States Government.’ If I made that offer to you, would you buy it from me?” Gabriel responded immediately. “You’ve got to be kidding! Why in the heck should I buy your old 5 percent bond when I can get a brand-new 10 percent bond from the Treasury and make double the income?”
“Because I’ll sell it to you cheap.” “How cheap?” “Make me an offer.” Gabriel pondered what might be a fair price. The old bond was paying $5,000 a year. But to get $5,000 a year from a new 10 percent bond, all he’d have to invest right now is $50,000. So he figured that’s what the old bond would be worth—$50,000. “Give it to me for half-price—50 grand. That’s all it’s worth to me.”
The adviser smiled. “Yes, yes. You got it! That’s very close to what the price would actually be in the open market. And that’s also why the market price on existing bonds invariably goes down when prevailing interest rates go up. It’s why rising interest rates are a major threat to everyone who owns bonds. It doesn’t matter who issued the bonds—a rinky-dink company or a Fortune 500 company, a struggling township in a blighted region or the United States Treasury Department—they’re all driven down by rising interest rates across the board.”
Linda was skeptical. “This all sounds very far-fetched. Has it ever really happened before?” “Ohh! Ab-so-lute-ly! In 1980, $10,000 30-year Treasury bonds plunged to $5,500. In 1981, Treasury bonds fell to $4,300. And 1994 was the worst calendar year for bonds in history—all in conjunction with rising interest rates. If you held onto the bonds till maturity, you’d eventually get all your principal back. But in the meantime, you’d be stuck with low yields for years and years.” Linda was despondent. She had come looking for advice on what to buy, but it seemed that all her adviser was doing was giving her advice on what not to buy. She came looking for hope, but it seemed all he could give her was more cause for despair. “You talk all about dangers and disasters,” she said. “Is that all you can see?”
He was pensive, then spoke softly. “You’re forgetting the Treasury-only money funds I told you about. With these funds, your income goes up almost immediately as interest rates rise. The more rates go up, the more you make.”
“Besides,” the adviser continued, “danger is a reality of our time, but even the worst disaster can be an opportunity. It can be an opportunity for you to build your wealth and for the entire country to fix itself. No matter how bad things get, we will survive and, ultimately, thrive.”
“OK, but you even talk about safe investments, like government bonds falling in value. You talk about people selling because of need, fear, envy, and God knows what else. We understand that now. Thank you. But how do we avoid these problems?”
“Just as I told you before. You loan your money only to those who are truly trustworthy, who spend the money wisely, who can almost surely pay back. That takes care of most of the problem right from the outset. Then, to take care of the other problems, you only trust them for a short period of time. For example, instead of lending your money for 30 years, you do it for just 3 years, or 1 year, or even just 3 months. The shorter the period, the less the risk of price fluctuations. If the initial term is from 10 to 30 years, it’s called a ‘bond.’ If it’s between 1 and 10 years, it’s called a ‘note.’ Anything under a year from the U.S. Treasury is called a ‘bill.’ The safest of them all is the Treasury bill, which takes us back to the Treasury-only funds. That’s essentially all they invest in.”
“But you said their rates are horrendously low right now!” “Yes. But what do you prefer—a low guaranteed yield on Treasury bills or huge losses on common stocks?” “Low yield, of course. But we can’t sit around in low yields forever. What could push them back up?”
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