Dear Mr. Berko: I have eight long-term maturity bonds from eight different public companies, each with coupons between 5.5 percent and 5.65 percent. They are all rated BBB, which is still bank-quality, and I paid about $10,000 for each bond. My stockbroker wants me to sell these bonds because he believes interest rates will go up to 10 percent in the next few years. He told me that these bonds, which I bought about a year ago, could decline in value by 50 percent. I am concerned that I would lose a lot of money if rates were to rise. But I don't understand how bonds could fall in price if the issuing bond companies maintain their credit ratings and earnings. Could you please help me understand this? Is my broker right about interest rates rising? I've been reading your column for 30 years. — HR, Jonesboro, Ark.
Dear HR: Interest rates will rise, but I believe that a 10 percent rate is unrealistic and that your broker's a blockhead, a bonehead, a lunkhead and a dunderhead. I should be able to answer your bond question, but please bear with me. After 45 years of writing this column, I'm discovering that it's so much easier to get older than wiser! So, here's my AARP version.
Assume today's interest rates are 6 percent and you've decided to invest $10,000 and buy a long-term AAA-rated 6 percent corporate bond that will mature in 30 years. That corporate bond will pay you $600 in annual interest until maturity. And if necessary, you could sell the 6 percent bond today (bonds trade actively on the market) for very close to what it cost you — give or take $50.
A week later, Jerome Powell, chairman of the Federal Reserve, announces that he must raise long-term interest rates from 6 percent to 12 percent. So you decide to buy a $10,000 long-term AAA-rated bond that will pay you 12 percent, or $1,200, in interest annually until maturity. And if necessary, you could sell the 12 percent bond today for what it cost you — give or take $50.
So, you have $10,000 invested in two AAA-rated bonds, both of which will mature in 30 years. One bond pays you 6 percent interest yearly ($600), and the other pays you 12 percent interest yearly ($1,200). Now it's six months later, and interest rates are still 12 percent. The Fed tells us they're likely to remain that high for many years.
Assume you wish to sell the $10,000 bond that pays you 6 percent interest. Because current interest rates are now 12 percent, how much would an investor be willing to pay you for it? Certainly, a knowledgeable investor wouldn't pay $10,000 for this bond because he could invest $10,000 and buy a bond that would pay him 12 percent.
Assume the investor pays you $8,000 for your $10,000 bond. Well, you have a $2,000 loss — and the investor will earn $600 in annual interest. Because he invested $8,000 to earn $600 in interest, his yield is 7.5 percent. Note that 7.5 percent of $8,000 is $600. But that's not good if long-term interest rates are 12 percent.
Now assume the investor pays you $7,000 for your $10,000 bond. Well, you have a $3,000 loss — and the investor will earn $600 in annual interest. Because he invested $7,000 to earn $600 in interest, his yield is 8.5 percent. Note that 8.5 percent of a $7,000 investment is $600. Again, that's not good if long-term interest rates are 12 percent.
But assume the investor pays you $5,000 for this 6 percent bond that cost you $10,000. Well, you have a $5,000 loss, and the investor will still earn $600 in annual interest. However, because he invested $5,000 to earn $600 in interest, the yield on this investment is 12 percent. And that's just right because current interest rates are 12 percent! Get it? Got it? Good!
Please address your financial questions to Malcolm Berko, P.O. Box 8303, Largo, FL 33775, or email him at [email protected] To find out more about Malcolm Berko and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.