Bonds and Interest Rates

Hello Folks,

Personal finance is like many other parts of life: the more you know, the more effectively you can make decisions. So, this posting addresses one rather important topic - the impact of interest rates on bonds.

This topic is important because if you're serious about money you will probably get involved with buying bonds at some stage in your career. Since interest rates are a hugely important part of the economy, you probably should know how bonds and interest rates relate.

Here are the main points:

• The prices of existing bonds rise when interest rates fall, and fall when interest rates rise.

• Bonds generate "fixed income" payments, so when interest rates change, a bond with a fixed payment will be worth more or less by comparison.

• When interest rates change, the price of long-term bonds changes faster than those of shorter-term bonds.

Interest rates present both risks and opportunities—particularly in today's low rate environment. This is important whether you invest in fixed income and want to do risk management, or if you are into bonds for income.

Interest rates today are less than in many years past - this has dropped yields to all time lows for money market funds and shorter-term bonds and CDs. Despite all the talk about inflation and potentially rising rates, interest rates have stayed relatively flat so far this year — but rates can't stay low forever. So you'll have to face this issue eventually if you are investing in bonds.

1) Bond prices rise and fall with interest rate changes.

Here's one way to think about it: When you buy a bond, you're typically guaranteed a "fixed income" stream, in the form of regular payment every 6 months. If you purchase one investment with a fixed payment, and then in a month from now buy a different investment promising a higher rate, the first investment you bought wouldn't be worth as much in comparison. Right, if you buy a bond at 4% and rates go to 6%, then nobody will want an investment paying 4% and thus your bond values drop.

It also works in the other direction. If rates fall and you can't buy another investment with a payment as high as what you're already receiving, your older investment would be worth more than any you buy with lower coupon payments. In other words, its value would rise, compared to what you've got available.

Here is a handy graphic:

2) Prices change faster for long-term bonds.

Prices fall a lot faster for longer-term bonds if rates rise, and vice versa, because you'll live with the fixed coupon payment for a longer period of time for a bond with a longer maturity. Right, if you have a 30 year bond that pays 4%, and interest rates jump to 6%, then people won't want your bonds because they they'll be stuck with a long term underperforming investment. The opposite holds true also - if you have bonds paying 6%, and rates go to 4%, then people will want your bonds.

3) Do interest rates matter if I hold bonds to maturity?

If you own individual bonds and don't need to sell before maturity, you need not be as concerned about their market values fluctuating based on changing interest rates. You'll still receive your promised coupon payments and repayment of the principal at maturity (assuming the issuer doesn't default). But, regardless rates will impact the value of your bonds on your bank statements. so, in the event you do need to sell your assets - or borrow against them - then this could be an issue.

4) Risk and Inflation.

For Treasury bonds, the risk of default is considered by some to be effectively zero. The risk of default rises with the credit quality of the issuer of a bond, from Treasuries to government-issued municipal bonds, all the way up to high-yield (“junk”) bonds. Generally speaking, higher yields are associated with higher risk.

Even if you do plan to hold to maturity, however, you might want to consider the importance of inflation. You want your fixed income payments to keep pace with the declining value of money. If inflation rises, bonds generally won't hold their value. This is one of the main risks for bond investors to balance when making an investment decision. If you are stuck in a situation like the 1970s where the value of your money declines at annual rates between 10% and 15%, then you could potentially loose some of your principle.

Relative to assets like credit default swaps, bonds are a very old and well understood investment class. As such, they make a lot of sense for people who are interested in lower risk investments or income producing assets.

Best,

James