Bonds have long been sought after for their stability and safety. For those following a disciplined asset allocation model, bonds likely make up a significant portion of their portfolio. Over time, this has been a well-devised plan. However, to continue holding significant positions in bonds in this economic environment will likely result in a catastrophic end.
In a recent Bloomberg article, Warren Buffett described bonds as "dangerous" and said that they "should come with a warning label." What makes bonds so dangerous now is how they work and their relationship with interest rates. Here is what you need to know and what you can do to protect yourself...How Bonds Work
A bond is a debt security in which the issuer agrees to repay borrowed money with interest at fixed intervals. Bondholders have a creditor stake in the company. Technically, bonds do not pay dividends, but instead they pay interest.
Interest rates play an integral part in determining the current value of a bond. Interest rates and the price of a bond are inversely related. The longer until a bond matures, the more susceptible its price is to changes in interest rates.
Consider two bonds, one that has a maturity of 30 years and another with a 7 day maturity. If after both bonds are sold, interest rates go up one percent, the price of both bonds will decline since new investors expect to earn the prevailing interest rate. However, the interest rate decline will affect the price of the 30 year bond more than the 7 day bond, due to the longer period of "lost" earnings. It works the same in the other direction - if interest rates drop the bond holder will sell it at higher price which lowers the yield to the market rate.