The Effect of Interest Rates on Bonds


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For the first time in many years the Federal Reserve is looking at raising interest rates.  They have already increased rates by a quarter of a point.  Over the next several years, depending on inflation and the strength of the economy, they may raise rates several more times up into the more normal 3-4% range.  They do this to try to control inflation and also to give themselves a little breathing room should another recession strike.  To use an analogy, they’ve had the accelerator petal stick to the floor for the last several years while we’ve been on this long hill and now that the hill isn’t so steep, need to be able to give it a little more gas should the car start to slow due to another hill.

Rising rates is good for people who have money in bank CDs since they will be able to turn in their CDs and buy new ones paying much better rates.  Maybe they’ll even be able to get four or five percent per year in a few years.  People who are currently invested in bonds in an effort to get a better return than they could from bank CDs, however, may be in for a rude shock as rates start to climb.  As rates climb for bank CDs, new investors in bonds will demand a higher rate before they will commit their money.  This will cause existing bond prices to decline.

You see, for existing bonds, because they pay a fixed amount every six months, investors demanding a better return will mean that the price of bonds must drop.  A bond paying $40 per year will pay 4% when the bond is trading at $1000 per bond, but paying that same $40 per year it will be result in an interest rate of 8% when the price of each bond is $500 for the investor who buys in at that price.  If bank CDs start paying 4%, bond investors will probably demand 8% from the average bond.  This means those holding bonds at $1000 each right now will see the value of their bonds cut in half if rates rise to that level.

Those who have bond mutual funds will see the same thing.  This is because the value of the bonds inside the mutual fund will decline.  Your fund may keep paying out the same amount of interest each year, but you might see negative returns overall for the next few years as the price of the bonds inside the fund drop by 10 or 20% each year as interest rates rise.  So the question is, should bond investors do something to protect their savings?  The answer is maybe no, and maybe yes.  It all depends on why you are holding the bonds and for how long.

To understand why, let’s look at the fundamentals of what a bond is.  A bond is a loan made to a company (or government body).  It has a fixed amount it pays per year, called the coupon, and a fixed maturity date when the loan will be repaid to whomever holds the bond.  When the bond matures, the company will repay the loan amount, which is normally $1000 per bond.  For whatever reason, the price of bonds are quoted in terms of the $1000 maturity price divided by 10, such that a bond selling for 90 would cost $900.  So if you hold the bond to maturity, and the company is able to repay the loan, you should expect to get $1000 per bond regardless of the price of the bond when you buy it, or what the price of the bond does while you hold it.

So if you are holding bonds right now that cost $900 per bond and they decline in price to $500, you can just wait until the bonds mature and you’ll get $1,000 each for them.  In the mean time, you’ll keep collecting whatever interest amount the bond pays.  For this reason, you really don’t need to worry about an increase in interest rates if you are planning to hold bonds to maturity anyway, meaning that  you are happy with the amount of interest that you are collecting and you don’t need to principle you paid in before the bonds are set to mature.

If you need the principle in a few years and the bonds aren’t set to mature for ten years, however, you have reason to worry.  If interest rates climb as they are expected to do, you may only have two-thirds or even half the amount of money you have now if you sell all of your bonds in a few years.  This means you should either sell the longer term bonds you have and buy bonds with a nearer maturity date for money you need in the next few years or just sell your longterm bonds outright and go into cash.  If you can stand a little risk, you could stay in bonds but just buy bonds set to expire before you’ll need the money.  These bonds won’t pay as much as ones that don’t mature for ten years, but at least you’ll be fairly confident that they’ll pay you $1000 per bond before you need the money.  If you have money you absolutely must have a in a few years, you should really go ahead and sell your bonds and put the money in bank CDs.  Given that rates are expected to rise, it may even make sense to put the money into a one-year or six-month CD so that you can switch into one that pays more in a year or so.

Another reason to sell your bonds is if you are holding bonds that are above the maturity payment rate.  For example, maybe you hold a bond that is set to expire in five years that is trading at 120, or $1200 per bond, because it pays a good interest rate so people were willing to pay more than the maturity price to get the interest payments.  If rates go up, the price will drop and it may never again go to $1200 per bond before it expires.  This means you’ll be locking in a 20% loss on the principle.  If the interest you are earning on the bond is high enough that you’ll still make out well even if you lose $200 per bond due to a decline in the price, you may go ahead and hold the position.  If not, it would make sense to sell and start looking for bonds below the $1000 mark.

Now what if you’re in a bond mutual fund?  Well, again it depends on how long you plan to stay in the bond fund.  If the managers tend to hold the bonds until maturity, it will be no different than if you held bonds yourself in your account.  (Note, if the managers don’t do this and you note a lot of churning in the fund because they’re trying to time the bond market, you’re in the wrong fund.)  So as long as you are able to wait long enough for the bonds that the fund holds to expire, it really won’t matter if the price of the bonds declines in the mean time.  If you need the money in the next few years and the average bond in the fund will not expire for ten years, you may want to look at shifting some money into cash or into a shorter term bond fund.  The shorter-term fund will see the bonds in the fund mature and then buy new ones that will probably pay a higher interest rate.

So with bonds the bottom line is that you should look at the interest rate (or really, the yield to maturity, which includes any loss you’ll suffer because a bond is trading above the price that will be paid at maturity)  and determine both if it is worth the risk that the company will not repay the loan and if it is reasonable compared to other places where you could put your money.  If you decide to buy, you should plan to hold the bond to maturity because then the price fluctuations won’t matter.  If the return is not worth the risk, wait until the price is better.  If you need the money soon and can’t wait for the bonds to mature, you need to look at bonds with a shorter life or just keep your money in cash.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

2 thoughts on “The Effect of Interest Rates on Bonds

  1. Pingback: The Effect of Interest Rates on Bonds – Bryan Caisse

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