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Posted on October 10, 2018

Why Bond Prices Fall When Interest Rates Rise

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Photo by rawpixel on Unsplash

Published by Robert W. Huntley, CFP®, CHFC®, Founder & Wealth Advisor

You’ve probably seen that rising interest rates are bad for bonds. Do you know why?

It’s a simple concept, but I find that people have often never had it explained to them.

Suppose you have $1,000 available to invest and decide you want to buy a bond issued by the ACME BRICK company, “ABC.”

ABC wants to build a new building to make more bricks. They don’t have enough cash laying around, so they need to raise the money somehow. They consider three primary ways to raise the money:

  1. Go to the bank and borrow the money.
  2. Issue more stock shares to sell to new investors.
  3. Issue new bonds to borrow the money from private investors.

They decide to go with issuing bonds at $1,000 face amounts, paying 5% interest for 20 years.

Let’s say you are one of those private investors looking to own bonds. You see ABC is offering a new bond with a face value of $1,000 that will pay you 5% interest for 20 years. After the 20 years, ABC will return your $1,000 to you, guaranteed by the full faith and credit of ABC.

You like ABC and feel like it’s a solid company. You also like the idea of getting 5% interest! So, you buy one bond, happily writing them a check for $1,000.

The interest starts coming to you quarterly. You’re feeling good about getting such a good interest rate. You keep seeing stories about how well ABC is doing and that business is great! That makes you feel secure that your money is invested soundly.

However, during that year you also keep seeing headlines about the Federal Reserve raising interest rates. You’re not sure if that matters to you but it seems to be a big topic on all the news channels.

You also start to see on your monthly brokerage statement that your ABC bond is going down in value. But your interest payments are staying the same.

ONE YEAR LATER.

It’s now been 1 year since you bought your ABC Bond. You’ve received $50 in interest total for the first year. You’re feeling good about that, but your statement shows a big drop in value and you’re concerned. Why?

ABC is now offering newer bonds and today they will pay 6% for the same $1,000 invested. You think to yourself “I’m getting 5%. I’d rather get 6%.”

You call up your broker and tell her you’d like to sell your 5% ABC Bond, so you can buy one of the new ones that are paying 6%. She says that your bond will not be worth $1,000 since interest rates have gone up so much the past year. She then explains how this works. It’s mostly a simple math problem, and the math looks something like the following:

If a new investor in ABC Bonds can get 6% on their $1,000 investment, it makes sense that they don’t want to pay you $1,000 to make only 5%.

Instead, the bond market will do the math and figure out how much your bond is worth to pay the same 6% yield that new ABC bonds are paying.

New investors demand 6% yields, so here’s the math comparing the two bonds:

If,

$60 interest divided by .06 yield = $1,000 (a new ABC bond)

then,

$50 interest divided by .06 yield = $833. (your old ABC bond)

Your bond is only paying $50. An investor buying your bond will only pay you $833 because that’s the price it takes to make your bond yield the same 6%.

$50 interest divided by .06 current yield = $833.33

The bond market is simply all the buyers and sellers of bonds out there who are setting prices of each bond based on supply and demand. They’re also comparing yields of newly issued bonds to existing bonds.

That’s why it’s a simple math problem. No one wants to pay the same for a 5% yield when they can get the exact same bond paying 6%. So, the values must be adjusted to equalize the yields. That’s why older bonds go down in value when interest rates are rising.

So even though ABC is still a great company, has paid its interest faithfully and is expected to keep doing so, because market rates have gone up your bond has theoretically lost almost 17% of its market value in just the first year!

After seeing this, you decide not to sell. You’ll keep collecting your 5% and just not look at your statements.

That’s the good news. You don’t have to sell the bond and it will keep paying you the 5% until the bond matures. If you hold on for another 19 years you will get your principal back, assuming ABC stays in business and honors its commitments.

Keep in mind, this is simply a hypothetical math demonstration of how bonds are potentially impacted by rising interest rates. In real life, there are many other factors and costs to consider when buying/selling bonds.

These risks apply to both corporate and municipal bonds. There is a business rate risk of the issuing company/entity. There are general market emotions of fear and greed. There can be currency risks and macroeconomic trends that impact bond values.

Interest rate risk is not the only risk to bond investing, but it is a present risk today due to historically low rates. I find it’s not well understood by investors who have been desperately seeking higher yields on their money that’s been earning so little in interest offered at banks.

We are not big fans of owning bonds today. However, if you are going to own them, we recommend owning individual bonds using a laddering approach. That’s a way to have some of your money maturing each year so you can reinvest in higher-yielding bonds if interest rates keep rising.

We expect interest rates to keep rising while the economy keeps doing well. Due to the simple math showed above, your bonds will fall in value as interest rates go up. It’s simple math. Don’t get caught without being fully aware of the risk you are taking.

We can evaluate your actual bond holdings if you’d like a personal review. Just call the office or send us an email.

 

The above information is designed to provide accurate and authoritative information on the subjects covered. It is not, however, intended to provide specific legal, tax, or other professional advice. For specific professional assistance, the services of an appropriate professional should be sought.

 The return and principal value of bonds fluctuate with changes in market conditions. If bonds are not held to maturity, they may be worth more or less than their original value.

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