The Mathematics of Bond Pricing and Interest Rate Risk

According to the Securities Industry Association, investors lost one trillion dollars in bonds in 1994. The total loss on a 20-year Treasury bond was 7.66% through Dec. 20, 1994. Holders of 30-year Treasury bonds lost 24% of their value. Disappointed investors pulled $10.9 billion out of bond funds in November 1994.

"Don't even mention the name bond fund in my presence," says Richard Rodriquez, 43, a Los Angeles business owner who lost $6,300 in 11 months. "The whole thing has shocked me so much that I'm afraid to do anything," says Mildred Kaplan, a retiree in Boca Raton, Fla., who lost more than $50,000; ". . . we were just trying to have more to live on."

"People misunderstand bonds all over the place," says George D. Kinder, a financial planner in Cambridge, Mass. He continues, "In general, they aren't aware that . . . It's a basic principle that as longterm rates rise, the value of bonds drop, and vice versa. It's something everybody should know."

The year 1994 was a bad year for bonds. Since 1926, only one year has been worse. Substantial losses on Treasury bonds don't happen often. In the last 68 years, there have been only 19 years in which they declined in value. In only 11 years did they lose more than 2%. Bonds are considered a reliable investment.

Why do people invest in bonds? They buy bonds to receive a return in the form of interest plus get money back at the time of maturity of the bond. How could people lose money on a bond?