Bond Gains and Losses

The previous blog gave some information about how an investor can make or lose money on a bond when it is not held to maturity. When a bond is held to maturity the investor gets the face value. A $1,000 zero coupon bond regardless of the interest rate when purchased will pay the holder $1,000 at maturity and the transaction is between the issuing entity and the investor. If not held to maturity, the price is set in the secondary market and the transaction is between investors.

Let's go into more detail on this topic by looking at long term bonds at 10, 20, & 30 years in duration. If the normal interest rate on a long term bond is 5%, let's look at a higher rate of 7% and a lower rate of 3%.

Our example will be a $1,000 bond that has no coupon. The value of a 10, 20, and 30 year duration at 3 & 7% is shown below:

10 Year Values: 3% = $766, 7% = $544
20 Year Values: 3% = $570, 7% = $277
30 Year Values: 3% = $424, 7% = $141

If an investor buys a 30 year zero coupon bond at 7% the cost is about $141. If it is held for 10 years and the interest rate is still 7% the price is about $277, a $136 gain. If it is held for 10 years and the interest is 3% the price is about $570, a $429 gain. Having the interest rate drop resulted in an additional increase in value of about $293. This is a beautiful thing as the investor got about 4 times the initial investment over a 10 year period.

What happens if we do this in reverse. If an investor buys a 30 year zero coupon bond at 3% the cost is about $424. If it is held for 10 years and the interest rate is 7% the price is $277, a $147 loss. This is a terrible thing as the investor lost about one-third of their money.

Bottom Line: If your buying long term bonds and you think interest rates will be falling then you have an opportunity to get a capital gain. Currently, with long term interest rates are at or below historical levels I am not sure that now is a great time to become aggressive in long term bonds for the average investor. An investor that is buying long term bonds in this environmen t should review their investment savvy and ability to be nimble.