Some people are confused as to how you can lose money selling treasury bonds, since they are supposed to be “safe” assets (the government is not expected to default on its loans, and, if it does, the economy probably has bigger problems). Economist Bob Murphy put together a great explainer thread on Twitter, which I will largely follow here.
Let’s say that there is an asset that always yields a 1% return every year on however much you have invested, but you never get the principal back except by selling it to someone else. Let us call this asset ABC, and let us say that it is completely riskless. If you buy $1,000 in ABC, you will get $10/year forever. You have essentially bought an income stream. If the typical interest rates I can get elsewhere are also 1%, I can probably sell that on the market for what I paid – $1,000.
However, let’s say that the interest rates increase, and they are now at 5%. My ABC asset, however, only pays 1%. This means that some other asset being offered today, call it DEF, will pay $50 a year for that same $1,000. So that means that no one will want to buy my ABC, because they could get a better deal elsewhere. So, how much would I have to lower my asking price for ABC so that someone in the current environment would be willing to buy it?
Essentially, we have to ask ourselves, if someone were to be buying a $10/year income stream in the current environment, how much would they have to pay? At 5% interest, you can get a $10/year income stream for only $200! That means that, if I want my capital back, I can only get $200 for my original $1,000 ABC investment, despite the fact that the investment is 100% safe!
Now, let’s compare our theoretical example to real examples. In reality, bonds eventually pay back the principal. However, the more long-term the bond is, the more it acts like our theoretical example, because, if you ever wind up needing the money now, this is how other people who might pay for your bond will react.
As long as you have the ability to hold the bond to maturity, you don’t necessarily have a problem other than the fact that you could be making more money than you are. However, if you ever need to actually access your cash before that time, then increasing interest rates in the economy means that you must sell the bonds, and sell them for a loss. Even if they are 100% safe.