How safe are bonds?
How can a promises to pay you $100 a year for 9 years and $1,00 in ten years be a risky investment if you know that you will actually get your money?

To answer this question, consider buying a house. When you buy the house you are paying for shelter and, assuming that there are no natural disasters, you will be able to live in that house for ten years during which you will make a monthly payment to the bank. How can this be risky if your payments are fixed and you get to live there? You could lose if you found the sales price of your home declined in value - you could win if it increased in value. This is exactly the same with bonds.

To see this, consider the following simple example. The future value column tells you how much money you will receive at the end of each of the next ten years by buying the BOND. If interest rates are 10 percent, the price of the bond (the present value of the future payments) will be $1,000. This is how much you would have to pay for the promise to pay you $1,900 over the next ten years.

But what happens if interest rates change? The sales price of the bond depends on the interest rate. If interest rates fell to 6 percent, the price of the bond would rise to $1,294 - good news to the person who bought the bond for $1,000. This person has just made a gain of nearly 30% ($1,294/$1,000 = 1.294). This person would experience a capital gain just like the person who saw the value of her house rise by 30%.

If interest rates fell, however, it would be a bad day for the holder of the bond. If interest rates rose to 12 percent, the price of the bond would fall to $887. In this case the person who bought the bond at $1,000 would have lost $113, about 11 percent of the initial price.