How Much Do Bonds Suffer When Interest Rates Rise?
Bond pricing is important to understand when interest rates are rising. We’ll continue our discussion by focusing today on rising rates and then moving to falling rates…
If you own this 5% bond from ABC and the rate of interest in the overall market goes up, you will still be receiving the promised 5% from ABC. They can’t break their promise. However, If you want to sell the loan, do you think the person that buys from you is going to be willing to pay you $1000 for your bond when they could buy a new bond issued by ABC for 6%?
Of course, they would not. If you want them to buy your bond, you will have to sell it for less than $1000 so that the current yield of the bond matches what they can find for a similar bond in the market. So your bond has lost value if you need/want to sell it. Even if you plan on keeping it until maturity, if inflation is significant enough, the 5% dividend payments that you are receiving and the future value of your returned principle could end up being substantially less than you had originally invested in real terms.
In the above scenario, you were the seller of the bond whose price had fallen, but what if you were the buyer? If you buy a bond that is priced below par, then you will still receive the payments that the issuer promised and you will still receive the par value at maturity. So if you bought the above bond for $800 and you received the same 5% payments of $25 each six months ($50/year = 5%), you would be receiving 6.25% on your invested money. You would also receive $1000 back if you held the bond to maturity even though you only paid $800.
Thus, buying 30 year bonds in the early 1980’s was a spectacular investment because interest rates have dropped ever since. If you had done this, you would have either collected interest far in excess of market rates for the last 30 years, or you would have done this for a while and then sold the bond at a huge premium to face value whenever you decided to. (However, this is easy to see looking back, think about how hard it would have been to pull the trigger on that investment when everyone you know would be saying that rates only go higher and that you would lose money as rates continued to climb.)
Some other posts on Bonds we’ve done are: What is a Bond?, Treasury Inflation Protected Bonds, Shorting Treasury Bonds, Treasuries Might Be Risky, Are Other Bonds Risky?, & The Different Types of Bonds