How Do Falling Interest Rates Affect Bonds?

by Wes Bridel on February 9, 2011

in Stewardship

Falling Interest Rates are much more exciting for someone who owns bonds.  We looked at the affects of rising interest rates recently and now we’ll examine the opposite scenario.

This scenario would work to your benefit as the holder of the original bond.  If you own the same bond we mentioned previously with a $1000 denomination, but interest rates in the market drop to 4% and you plan to sell the bond, you would demand more than $1000 to part with the bond and investors would happily pay it.

If, instead of selling the original bond, you buy the bond that is priced above 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 $1200 and you received the same 5% payments of $25 each six months ($50/year = 5%), you would be receiving 4.16% on your invested money.  You would also receive $1000 back if you held the bond to maturity even though you paid $1,200.

Hopefully, you fully understand how devastating rising interest rates can be to a bond holder.  If you do not fully understand this concept, you should not invest in bonds!  This is a substantial risk that must be understood.

So ask yourself…How do falling interest rates affect the value of bonds?  While you’re at it, go ahead and review what happens when interest rates rise (as they have begun to do in the last few months).

Another type of bond that might be important to introduce here are Callable Bonds.

When considering a bond that is Callable, you need to understand that this  means that the company could pay you what they owe you early.  They would do this if interest rates in the market had dropped and they wanted to lower their rate of interest by issuing new debt.  Or they might have the cash to do so and simply decide to pay off the loan.

This makes falling interest rates not nearly as exciting to you as the bond holder!  You get your original principle back, but not the big appreciation that holders of non-callable bonds are able to enjoy.

Some other posts on  Bonds we’ve done areWhat is a Bond?, Treasury Inflation Protected Bonds, Shorting Treasury Bonds, Treasuries Might Be Risky, Are Other Bonds Risky?, & The Different Types of Bonds.

By the way, I’m sorry for the delay in posting.  I had a family emergency and had to get out of town very quickly.

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