Why Treasury Bonds Aren't Always So Safe

(Fortune) -- People often ask me how they can go wrong buying U.S. Treasury bonds. After all, they say, no matter how bad our fiscal problems get, the government can always print the dollars it needs to redeem its bonds. So what's the problem?

The five-word answer: "interest rates could go up."

Rather than give you the standard jargon -- "bond prices move inversely with interest rates" -- let me show you some numbers that help explain why rising rates pose a big problem to investors.

Let's say that you buy a 30-year Treasury bond that carries a 4.5% interest rate, which in today's world would trade at roughly its face value. (As bond mavens know, I'm oversimplifying all this -- but any other way lies madness, not to mention boredom.)

Now, let's say that next May, the going rate on long-term Treasurys is 5.5% rather than today's 4.5%. In that world, your bond, which is now a 29-year bond producing $45 of annual interest (4.5 percent of $1,000), is at a disadvantage compared with 30-year bonds that are producing $55 of annual interest (5.5% of $1,000.)

No one will pay $1,000 for your bond and give up $10 a year of interest for 29 years. If you consult a bond calculator, which you can find online in various places, you'll discover that in a 5.5% world, a 29-year 4.5% bond will sell for only $850 to $860 per $1,000 of face value.

To look at it another way, the decline in your bond's market value will have wiped out not only the value of your first year's $45 interest payment, but the next two years' worth of payments, too.

You don't have to sell your bond, of course. But if you don't, you're settling for $290 less total interest (29 years at $10 a year) than you'd get if you sold your 4.5% bond and bought a new, 5.5% bond. You can take your loss all at once by selling, or you can take it year-by-year, by getting $10 less of annual interest than holders of other bonds are getting. But the loss is there, regardless of whether you choose to recognize it now or over time.

You can argue that you're happy with a 4.5% return, which is fine. But you can't deny that you're getting less income than you would be getting had you been a more astute bond buyer.

Should interest rates climb to 6.5% two years from now, your now-28-year bond will be worth less than 75 cents on the dollar. So, you see, even though your income and principal are secure if you own a long-term Treasury security -- you have no "credit risk" -- you're exposing your investment to serious "interest rate risk."

What happens if interest rates on long-term Treasurys surprise me, and fall to 3.5% a year from now? Then you win, big-time. Your $1,000 bond will have a market value of about $1,180, because it will pay $45 of annual interest for 29 more years in a world in which new bonds pay only $35.

You may be wondering why a bond rises more in price if interest rates fall 1% than it loses in price if rates climb 1%. That's because the lower interest rates are, the more value that mavens ascribe to an extra dollar of interest in the future. For details, consult a math textbook or your local numbers geek.

Now you should understand why a bond's market value falls when interest rates rise, and why its value rises when rates fall.

More importantly, I hope that you now get the larger point: that you're putting your capital at serious risk if you make a long-term loan to the safest borrower in the world, the U.S. government. Sure, getting your interest and principal from Uncle Sam is guaranteed. But that doesn't mean that you're making a safe investment. Be warned.