For years, the Federal Reserve has done everything it could to keep interest rates low. But now that the Fed has started thinking about plans to cut back on some of the methods it has used to reduce rates, the bond market has suffered big declines, with losses of 10 percent or more for some types of bonds.
Here are five things you need to understand about bonds in order to make sure rising rates don't cause you any further nasty surprises.
1. Rising Interest Rates Hurt Bond Prices
Many bond investors make the mistake of thinking that rising yields on bonds are a good thing. That's true for new investors, as newly issued bonds will carry higher interest rates than older bonds.
But if you already own bonds, rising yields cause your bonds' value to fall. That's because as new bonds with higher rates come out, your lower-rate bond looks less attractive by comparison, and so buyers aren't willing to pay as much for your bonds, causing their prices to drop.
2. Longer-Term Bonds Move More When Rates Change
Typically, investors can get higher rates by buying long-term bonds. For instance, 30-year Treasury bonds pay almost 4 percent right now, compared to about 0.5 percent for two-year Treasuries.
By contrast, even if rates rise substantially on a bond that matures within a few months, you won't lose much value because you'll soon be able to take your money at maturity and reinvest it in a higher-rate bond. That's one reason why so many analysts have advised bond investors to focus on shorter-term bonds lately.
3. Individual Bonds Have One Big Edge Over Bond Funds
Most investors buy bond funds for diversification rather than individual bonds. With bond funds, you can get exposure to dozens or even hundreds of different bonds even if you only have a modest amount to invest. To buy that many individual bonds, it would cost you tens or even hundreds of thousands of dollars.
However, one attractive feature of individual bonds is that even if their market value declines due to interest-rate rises, individual bonds eventually recover to their full par value at maturity. For bond funds, on the other hand, capital losses can be permanent because most bond-fund managers typically buy and sell bonds rather than holding them to maturity.
4. Municipal Bonds: Attractive Yields with Tax Benefits
Within the bond market, different niches have had varying results. Municipal bonds have seen an especially large run-up in yields, and right now, 30-year municipal bonds have yields that are almost a full percentage point above comparable Treasury yields.
What's particularly unusual about the current muni-bond environment is that munis usually have lower yields than Treasuries. That's because muni interest is exempt from federal tax, providing even greater after-tax returns than taxable Treasuries and other bonds. The recent Detroit bankruptcy has highlighted the risks of muni-bond investing, but high yields make that risk worth it for many investors, especially if you're in a high tax bracket.
5. Inflation-Protected Bonds Can Still Lose Value
Most bonds are vulnerable to inflation. That's one reason why inflation-protected bonds like Treasury Inflation-Protected Securities, aka TIPS, have become popular.
Yet the rise in bond yields lately hasn't come from inflation fears but rather from the Fed's anticipated policy changes. As a result, TIPS yields have also risen, causing big price declines in them as well.
Be Careful With Bonds
Having bonds in your portfolio still makes sense for most investors who can't afford to take on the full risk of the stock market and other riskier assets with their entire portfolio. By keeping these five things in mind, you can do your best to minimize any losses and take advantage of opportunities as they arise.
You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger or on Google+.