Yesterday the Federal Reserve resumed purchasing Treasury bonds in hopes of bolstering the economy and fighting deflation fears. Purchases are being made with proceeds from principal payments on mortgage-backed securities. The Federal Reserve completed its $1.25 trillion purchasing program of agency mortgage-backed securities in March 2010.
According to the Web site for the Federal Reserve Bank of New York, the Fed plans to buy $18 billion in Treasuries over the next month, purchasing Treasury bonds and notes in maturities ranging from 2 to 10 years. They will release information about future purchases next month.
A Bloomberg.com article titled "Treasury Yield Near 17-month Low on Speculation Fed May Increase Purchases," reported this morning that Treasury prices jumped at the news and the yield on the 10-year Treasury note fell to 2.61 percent.
As investors pile into Treasuries the question now is: what will happen to individual investors when the bond bubble pops?
An opinion piece on the Wall Street Journal today, titled, "The Great American Bond Bubble" posits that if interest rates on the 10-year note double over the next year, bondholders will be in for large capital loss.
"Rates are either going to stay flat or go up but when they go up its going to be hard on bond principal," says Wayne Copelin, Certified Financial Planner and president of Copelin Financial Advisors in Sugar Land, Texas.
He recalls the rate increases of the 90s and the impact on the bond market then.
"In December of '93, the Fed Funds rate was 3 percent. Fourteen months later, rates had doubled. Greenspan raised rates three or four times during that period," says Copelin.
"The bond market got crushed. Everyone says, 'bonds are safe, stocks are risky,' but people got decimated. In October of '94 the cover story was The Great Bond Market Massacre," he says.
With Treasury securities, there's no threat to principal if you hold it until maturity. But if yields rise and you're stuck with a note that pays 2.6 percent, selling will be an unattractive option. On the other hand, 2.6 percent might be a hot ticket in a deflationary environment.
This Bankrate article from Dr. Don explains how to lose money on an investment in Treasury securities.