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If you
made life simple on yourself and bought U.S. Treasury
bonds early last year, you may be patting yourself on
the back now.
Treasurys
that mature in 10 years returned about 16 percent in
2011. Longer-term Treasurys gained more than 20 percent.
But as
these highly unusual gains have been reported in the
media, people new to bond investing have been wondering
how the phenomenal gains could have possibly happened
when they shopped for bonds and found only disgustingly
low interest rates. As one retiree wrote me: “I
haven’t wanted to buy Treasurys because they are
paying only 2 percent interest, and I’m not going to
be able to live on 2 percent. So how could a person earn
16 percent on those Treasurys paying 2 percent?”
The
answer goes to the heart of how investment gains, or
returns, are calculated for bonds.
If, for
example, a retiree were to go directly to the U.S.
government and buy a fresh 10-year Treasury bond that is
paying 2 percent interest, and he held it for the full
10 years, he would get paid the 2 percent interest he
was promised each year. And that’s all he would get,
not 16 percent.
On paper,
if he had a brokerage statement for 2011, the 10-year
Treasury bond he bought early in the year would have
been worth about 16 percent more at the end of 2011. But
it would have been a gain recorded on paper, not one the
investor could spend unless he was willing to sell his
bond at that higher price. But some investors do buy and
sell bonds without waiting for them to mature. And if a
person bought a 10-year Treasury bond at the start of
the 2011 and sold it at the end of the year, he ended up
with about a 16 percent return. That total return came
from combining the appreciation on the price of the bond
and the interest he collected during the year.
Likewise,
if the person didn’t buy individual bonds but put
money into a bond mutual fund that selected U.S.
Treasury bonds, he would have seen at the end of 2011
that he probably gained more than 14 percent for the
year. If at the point, he decided to remove his money
from the fund, he actually would have captured the 14
percent gain. Money left in the fund could have gained
or declined.
What
happened in 2011 was unusual. And here’s how the gain
occurred. At the beginning of 2011, people were
expecting the economy to improve, and so yields on
10-year Treasurys were a little over 3 percent. But as
the year went on, investors became increasingly nervous
as the economy started to look like it might go back
into a recession. Consequently, nervous people piled
into U.S. Treasurys for safety, and the combination of a
lousy economic environment, a promise by the Fed to keep
interest rates low and the popularity of Treasurys made
yields slide to unusually low levels. By the end of the
year they were paying just under 2 percent. That meant
that bonds yielding 3 percent earlier in the year were
much more valuable than those late in the year at 2
percent. So those early 3 percent bonds gained about 16
percent in value.
If this
is confusing, as it is to many, just answer this simple
question: If you were given a chance to earn 3 percent
interest or 2 percent interest, which would you choose?
Clearly, if you had a choice of two bonds that were
equal in safety, you would want the one paying 3
percent, not 2 percent. So at a time when new bonds are
paying about 2 percent and older bonds are paying 3
percent, people want those older bonds. If you happen to
be holding those older 3 percent bonds, you will find
that they will become extra valuable. If you decide to
sell them, you will get back more money than you
originally invested.
If you
yearn for similar gains, keep in mind that a 16 percent
return is not likely to happen this year. If interest
rates keep falling because people fear recession, there
could be another nice gain. But yields have fallen a
lot. To go to zero percent this year, the world would
probably have to go into a serious recession. Even at
zero, the bond math would result in a gain of only about
16 percent, said Matt Tucker, a managing director of
BlackRock’s fixed-income portfolio group.
It’s
more likely that at some point in the future the bond
math will work in the opposite direction. Interest rates
will start climbing as the economy improves, and people
will prefer rates of 3 or 4 percent that eventually
become available. At that point, investors won’t like
2 percent anymore. And today’s bonds will lose, not
gain, value. The question is when this will happen, and
no one knows.
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