Interest Rates and Bond Risk

The Federal Reserve is tasked with two primary objectives: maintain price stability, and maintain high employment.

Maintaining price stability means, simply, keeping inflation pretty low without pushing us into deflation.

Maintaining high employment... well, that means keeping unemployment low (not sure how else to explain that obvious objective).

In both cases, the most effective tool at the Fed's hand is raising or lowering the interest rates. Lower rates stimulate the economy because it makes it easier/more affordable for people and businesses to borrow money. Raising rates tames inflation by slowing down the economy.

But interest rates affect the value of bonds. Bonds, as I've posted here before, are thought to be the "safe" place to invest, but they do fluctuate in value. Rising interest rates force bond prices lower; falling rates lift bond prices.

Most folks buy bonds in order to get predictable income streams, not capital gains. Hold a bond to maturity, in fact, and you get your original money back. Your benefit was the income the bond paid while you owned it.

So, if interest rates are so low, aren't bonds scary now--won't they be likely to go down in value? Yes. If and when the Fed starts raising interest rates.

But that should only happen when the economy starts growing too fast again. We're just hoping it's really even starting to grow now. Some experts think it won't be for another year or two that the Fed will start raising rates.

So, this is potentially good for bond investors who need income or who seek relative safety compared to the volatile stock market. Alas, other forces could work against interest rate stability. If the USA's spending remains in deep deficit mode, we might need to offer higher rates on our more risky Treasury bonds when we sell more to fund our ongoing deficits.

The key is to know what you have and to have an exit plan. Most individuals should not tinker with individual bonds right now. It would be better to have a private portfolio manager run things, or to use a reputable and successful bond mutual fund.