Stocks finished the week on a mixed note, with gains for the S&P 500 ( ^GSPC 0.51% ) and Dow Jones Industrial Average ( ^DJI 0.44% ) but a slight pullback for the Nasdaq Composite ( ^IXIC -0.16% ). Even going into a weekend during which any number of uncertain situations across the globe could worsen, investors nevertheless were confident enough in the longer-term prospects for the stock market to keep share prices up throughout much of the market.

Index

Daily Percentage Change

Daily Point Change

Dow

+0.44%

+153

S&P

+0.51%

+23

Nasdaq

(0.16%)

(23)

Data source: Yahoo! Finance.

Many investors who have felt fear in light of the stock market’s declines so far in 2022 have looked frantically for alternatives perceived as having less risk. In particular, bonds are often portrayed as being safer than stocks, and many investors use balanced portfolio allocations to try to reduce their overall volatility. Unfortunately, bonds have proven vulnerable to a type of risk that many investors never took into account. In some cases, that has led to even worse year-to-date returns for the bond side of their portfolios than for stocks.

Old-style paper bond showing interest terms.

Image source: Getty Images.

A big week for rising interest rates

The bond market is usually calm and relatively stable, but this week bonds saw considerable volatility. Consider the weekly moves in some key Treasury yields:

  • The yield on the 10-year Treasury started the week at about 2.15%. By the end of Friday, it was approaching 2.50%.
  • Five-year Treasuries started at about the same 2.15%, but they rose even further, finishing at 2.57% and creating a small inversion in the yield curve.
  • Two-year Treasuries yielded less than 2% at the beginning of the week, but they closed at around 2.30%.

Those changes in interest rates might not sound like a whole lot. But the impact on prices was substantial. In just a week, the long-term iShares 20+ Year Treasury ETF ( TLT -1.39% ) lost close to 4%. The intermediate-term iShares 7-10 Year Treasury ETF ( IEF -1.03% ) was down almost 3% in the same period.

Losing its balance

Rising interest rates have been a problem for the bond market all year, and that has generated surprising losses for investors in bond funds. The long-term iShares bond ETF has fallen 13% year to date, which is worse even than the Nasdaq’s roughly 10% loss. Declines for the intermediate-term iShares bond ETF have been less severe at 8%, but it’s still much worse than the 5% drop for the S&P 500 year to date.

TLT Chart

TLT data by YCharts.

Many investors are nevertheless shocked that their bonds could lose value at all. This stems from a misunderstanding of risk in the bond market. It’s true that Treasury bonds are almost completely safe in the sense that the U.S. government is highly unlikely to default on its obligation to repay the bonds when they mature.

However, even though bonds are essentially guaranteed to pay their face value when they mature, that doesn’t mean their prices are stable in the market before maturity. When prevailing interest rates in the broader bond market rise, bonds whose interest rates were fixed at lower levels look less attractive than the newer bonds getting issued with higher rates. That sends the prices of those lower-paying bonds down in order to make up for their less attractive payouts. If you have to sell those bonds before maturity — or if your bond fund does so — then you won’t necessarily make back those losses.

Bonds can play a valuable role in investment portfolios, but you still need to be aware of how they’ll behave under different market conditions. Right now, the risks of bonds are more evident than ever.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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