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Previously, we discussed the potential to invest in short-term bonds and earn a 5% rate of return.

This may sound appealing, similar to the expected rate of return in the stock market. However, viewers raised concerns about the risks associated with these short-term bonds and why everyone isn't taking advantage of them.

✅ Let's begin by looking at the risks of owning short-term bonds that offer a decent rate of return. Currently, as of mid-July, the return on a six-month treasury bond is around five and a half percent. This means you can invest in a treasury bond and earn a rate of return of approximately five and a half percent over six months.

The risk associated with short-term bonds is not related to default, as the treasury can print its own money. Additionally, the interest rates are locked in for the six-month period. However, the risk lies in the possibility that after six months, interest rates might significantly drop. If rates were to go to zero percent, for example, you wouldn't be able to reinvest at the same high rate. This risk is known as reinvestment risk.

To illustrate, let's say you invest one dollar in a six-month bond and earn a five percent return. At the end of the term, you reinvest the money, but the new rate is lower. Consequently, you lose the potential interest you could have earned if you had locked in a higher rate for a longer period of time. In this case, you don't lose your initial investment capital, but you miss out on potential interest earnings.

✅ Now, let's consider the risks associated with long-term bonds. If you prefer to lock in an interest rate for a longer period to avoid reinvestment risk, you might opt for a thirty-year treasury bond that offers a four percent rate of return. With this choice, you don't need to worry about reinvesting at a lower rate.

However, the risk with long-term bonds is different. It's called interest rate risk, and it manifests in a distinct way in your portfolio. Last year, for instance, we observed rising rates causing the value of long-term bonds to decline. Here's why.

When you purchase a thirty-year treasury bond with a fixed rate of four percent and interest rates increase, say to five or six percent, the value of your bond decreases. This relationship between price and interest rates is like a seesaw. When interest rates go up, bond prices go down, and vice versa. The longer the bond's term, the more significant the price changes.

For example, Vanguard offers a long-term treasury fund with a duration of sixteen years. Duration represents the price change for every one percent change in interest rates. If interest rates decrease by one percent, your bond's value increases by sixteen percent, which is favorable. However, if interest rates rise by one percent, your bond loses sixteen percent of its value.

It's important to note that predicting the direction of interest rates is challenging. Many income investors buy bonds for stable income rather than speculating on price changes, especially when short-term rates are higher than long-term rates. Therefore, it's essential to weigh the risks carefully.

When considering fixed income investments like bonds and assessing risks such as reinvestment risk and interest rate risk, it's crucial to understand your investment goals. If your aim is to generate income without losing capital or jeopardizing a portion of your portfolio, these risks have different implications.

⚠️ Remember, it's essential to understand what you own and why you own it.

We hope you found this video helpful and as always, thanks for investing your time with the personal CFO.

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