If you have savings, then some of them are probably invested in bond funds. Which worries a lot of people. Because rates are very low right now, and they’re bound to go up at some point. And when rates go up, bonds go down in value.
So what’s going to happen to your savings when rates start to rise? That depends on two things: the riskiness of your bond fund, which is measured in something called duration, and the speed at which interest rates go up.
Let’s look at duration first, and assume that rates rise slowly, at just 0.5% per year.
2. The higher your bond fund’s duration, the more money you can lose
Total value of a $1,000 bond fund over time, with interest reinvested, and yields rising steadily at 0.5% per year.
If you click the little hand in the top-right corner, you can rub the GIF back and forth to see what happens at different durations. (This works best on a touch device, obviously.)
The duration points we chose might seem weird, but they’re not: they correspond to the duration of benchmark Treasury bonds. The 1-year bill has a duration of 0.997; the 2-year is 1.946, the 3-year is 2.962, the 5-year is 4.771, the 7-year is 6.458, and the 10-year is 8.622. And the initial yields we used are just the yields on Treasury bonds of those maturities. So what we’re looking at here is pure interest-rate risk.
The blue curve shows the value of your bond fund over time, assuming that your interest payments are reinvested at then-prevailing rates. Here’s a list of various bond indexes. The big ones, the US Universal and the US Aggregate, have a duration of about 5.5, but depending on the maturity of the bonds you’re invested in, your duration could be less than 1 or more than 10.
And that makes a big difference. If the duration is low, then you’ll never lose much money at all. But if you have a more typical bond fund, designed for long-term investors, then you could lose money for two or three years, and not get back to even for four or five years. Even when rates are rising very modestly.
4. And if rates rise more quickly, you could really start losing money.
Total value of a $1,000 bond fund over time, with interest reinvested, and duration held constant at 5.57, with an initial yield of 1.5%.
The second GIF shows what happens to $1,000 invested in a bond fund with a typical duration of 5.57, as rates rise more and more rapidly. When rates only go up at 0.5% per year, the losses are quite easy to bear. But if they rise faster than that, then you can lose a significant chunk of your money the first two or three years.
In general, it’s true that bonds are safer than stocks. But as you can see, there’s an exception to that rule. When rates are rising quickly, bonds can lose a lot of their value. That’s something to bear in mind right now, when rates are low. Because over the next few years, you can be sure they’re going to rise. The only question is when — and how fast.
(With many thanks to Emanuel Derman, this skewtosis tool, and, especially, to BuzzFeed’s Jake Levy for putting the charts together.)