What happens to bond prices when interest rates rise

The effect of interest rate rises on bond prices is a very misunderstood event, that I will attempt to clear up in this post.  It is true that the trade-able value of a bond is linked intrinsically to interest rates, but they have guarantees and securities beyond this, and understanding how they work will make a massive difference to the way you invest.

Bonds are a record of a loan you make to the bond issuer, in exchange for you lending them money they issue you a physical an agreement to pay back your money by a fixed date, and they will pay you annual interest on that loan.   The two ways that a bond can pay interest would be a face value bond with a coupon- such as a 10 year Treasury bond with a yield of 2.99% annual interest.  This would cost you $10K to buy and have a redeemable value of $10K in 10 years from now.  Until that time the Government guarantees that it will pay you 2.99% interest every year on that money.

The other type would be like you find with a Series EE Savings Bond.  This you buy at half face value, it has no annual interest but at the maturity is worth what it says on the face on the bond.  For example if you were to take 10x$100 bills to a bank and ask to buy Series EE bonds with it they would issue you with $2,000 worth of bonds, but they couldn’t be cashed in for $2,000 until the maturity.

Some terms you need to understand when dealing with bonds would be:

• Face Value -also known as Par Value or Par, this is the amount that the bond will be exchangeable for cash at its maturity.
• Coupon – this is the amount that the bond issuer will pay you each year in the form of interest for holding the bond.
• Yield – the percentage of interest your investment receives.  Calculated by Coupon Amount/Purchase price.
• CUSIP – the identifier of the bond, the same way a Stock has a Ticker symbol.
• Rating – There are several rating agencies, they all use slightly different terms for the same rating – in the US Moody’s (Aaa through C) and S&P (AAA-D)  are most well known.
• Callable – Bonds are loans from you to the company (or government) and some have a clause where if they have the wherewithal they are able to repay you in full early.  When the company ‘calls’ the bond they will pay you the price agreed upon for this, it normally includes a premium above the face value of the bond.

What happens to bond prices when interest rates rise

The bond Issuer is asking for a loan, there is a risk with loans that they won’t be repaid (the credit rating assigned by Moody’s and S&P is used to determine the chance that the loan will default, and even AAA rated bonds could default in theory.  As such, they need to pay investors interest on the bond in order to make it attractive to take the risk.  AAA rated bonds pay less interest than AA- rated Bonds because there is less risk.

A simplified example:

If the current Interest rate is 1% a bond issuer could offer $10,000 bonds with a yield of 1% (interest rate) + 2% (premium for the risk of the loan) to borrow the money from you in a 10 year bond.  Imagine, 4 years later the company needs another loan so issues more $10,000 10 year bonds  If the interest rate rises to 2% and they issue a new bond with a 2% (interest rate +2% (premium) the second bond is worth that much more, because it pays 4% yield vs the 3% yield of the first bond.

• Bond A will pay the holder 3% for the duration of the loan and then will be worth $10,000 when the 10 years is up (6 years remain)
• Bond B will pay the holder 4% for the duration of the loan and then be worth $10,000 when the 10 years is up (10 more years)

The confusion arises because you can trade bonds daily – you could, in year 8, when Bond A is 2 years from maturity, and Bond B is 6 years from maturity, buy either bond on the market (assuming there is a seller).

If you were to look at both of these bonds, the Bond B would be much more attractive, because it pays more money every year in its Coupon.  If the bonds traded in year 8 without a change in price value one would Yield 3% and one would Yield 4% per year.  In order to balance that up, Bond A would trade below its face value to remain competitive in the market, its trade-able value would drop proportionately so that the 3% Coupon paid a 4% yield.

Remember – Coupon is a fixed payment, if the Bond becomes cheaper, the Yield Increases, if the bond becomes more expensive, the Yield Decreases.  Bond Prices fluctuate daily, but Coupons do not.

Let’s not forget the key here though- when the maturity is due, 10 years from issue – the bond is worth face value, and will be exchanged for $10,000 again.  Therefore, if you were able to buy Bond A for $9,950 on the market in year 8, you would be getting 3% for 2 years, then you would be able to sell the bond for $10,000 and make another $50.

The fear for the bond investor is if the rates rise, their bond will become unattractive in comparison to new issues, and it will therefore lose trade value, so if you were today to buy $100,000 worth of bonds, and then the rates go up tomorrow you would be able to only sell those bonds at the market price of say $95,000, so you are losing money.  However, the bonds will still pay you interest every year in their Coupon (this is fixed income) and regardless of what they currently are worth today, when the 10 years is up they are worth $100,000 again.

So really, you aren’t losing money, though it might feel like it.  For that reason, when you actually try to trade bonds close to a maturity they will never be vastly discounted even if they pay off a terrible Coupon, because when the maturity date comes up they become worth face value again.

Opportunity Cost and Opportunities Lost

The real problem of buying bonds and then having interest rates rise is that you are locked into your money.   You have agreed to accept their Coupon for the duration of the Bond, and when the rates rise your irritating next door neighbor is able to lend the same company the same amount of money in the new Bond Issuance and get more of a Coupon every year.  Since your present day value has reduced (nobody wants your bond until maturity) you are stuck with them, if you sell to free up your money and chase the latest rate then you get stuck with having to sell at below face value in order to offset the fact that your Coupon doesn’t pay the best.

However, whilst you are sitting there wondering when rates will rise, you are also losing out in coupons every month, so whilst jumping in could force you to be stuck with a lower performing coupon, holding off will mean that your cash doesn’t earn a coupon every month.

It really comes down to how much money you have and how much you need.  If you were able to lock up your funds for the duration of the bond and not worry about interest rate changes then you would be fine, but if you need the money prior to the maturity date you could be in trouble.  Remember – a Bond is a Loan to a company.   If you cannot afford to lend the company the money for the duration of the loan you should not be loaning them the money!

So, don’t be afraid to buy bonds, if they are trading close to face value and pay a Coupon that you find attractive then you will be OK, just remember that the safest bonds (AAA Rated) won’t pay that much due to their low risk of default.  And short term loans (think 1-3 year Bonds) don’t pay as much as they are going to redeem at face value very soon.  They would be good options if you, like I do, want to get defensive with your portfolio.