Bonds
March 7, 2023 Beginner
Interest rates and bonds often move in opposite directions. When rates rise, bond prices usually fall, and vice versa. Learn the impact this relationship can have on a portfolio.
As an investor, it's important to understand the relationship between bonds and interest rates. After all, the U.S. fixed income market is by far the largest in the world, comprising 39.2% of the $128 trillion securities outstanding across the globe, according to SIFMA as of early 2022.
You might not be focused on how interest rates can impact bond prices, but you should still understand the relationship between the two. Keep in mind, bonds can be an important component of a diversified portfolio, and they'll likely become a more important part of your portfolio as you get closer to retirement. So, what does happen to bond prices when interest rates rise?
What happens to bonds when interest rates rise?
Most bonds and interest rates have an inverse relationship. When rates go up, bond prices typically go down, and when interest rates decline, bond prices typically rise. This is a fundamental principle of bond investing, which leaves investors exposed to interest rate risk—the risk that an investment's value will fluctuate due to changes in interest rates.
The relationship between interest rates and bond prices can be a little confusing at first, but it's important to understand so you can make informed investment decisions when considering bonds and other fixed income products.
If you intend to hold the bond to maturity, interest rate risk may be less of a concern for you as it'd be for someone who might need to sell the bond before it reaches maturity and may be forced to sell at a discount to par value, or below the bond's initial purchase price.
Most bonds are issued at or near par value, usually $1,000. The issuer receives this money when the bonds are first offered and, in return, promises to pay investors a stated fixed interest rate (the "coupon rate") at regular intervals with the intent of returning that initial investment of $1,000 back to bondholders at maturity.
After a bond is issued, it can be traded in the secondary market, causing the bond's price to fluctuate depending on supply and demand, changes in interest rates, and any news about the financial health of the issuer that could impact its ability to honor the obligations of the bond.
When interest rates rise, existing bonds paying lower interest rates become less attractive, causing their price to drop below their initial par value in the secondary market. (The coupon payments remain unaffected.) Current bond yields are calculated by dividing the annual interest payment by the bond's current price (current yield = annual coupon ÷ bond price). So, when the bond price drops, its yield increases, making it competitive against newer bonds paying higher rates.
In short, bond prices and bond yields move in opposite directions.
Here are two scenarios of investors buying bonds with the same par value but different interest rates.
Scenario 1: An investor buys a bond for $1,000 with a 10-year maturity and a coupon rate of 2%. The par value would be $1,000. The investor will receive annual interest payments of $20. After 10 years, the investor will receive their $1,000 principal, with $200 in interest, barring default.
Scenario 2: Meanwhile, interest rates rise and an investor buys a 10-year bond with a $1,000 par value that pays a coupon rate of 3%. The investor will receive annual interest payments of $30. After 10 years, they'll receive their $1,000 principal, after collecting $300 in interest.
So, the first bond then becomes less valuable because it's producing less income. Essentially, its market value declines. If the investor wanted to sell the first bond before the 10-year term ends, they'd likely have to sell it for less than $1,000. They'd lose money on the principal and would not receive the remaining interest payments. In this case, the rise in interest rates pushed the bond's market value lower.
What happens to bonds when interest rates fall?
When interest rates fall, bond prices typically rise, and there may be an opportunity to profit if an investor sells the bond before maturity. Let's assume an investor bought a bond with a 10-year maturity, a coupon rate paying 2%, and purchased it at its par value of $1,000.
But interest rates fall to 1%. Now, the coupon on their bond is more attractive than current market rates so investors would be willing to pay a premium—above par value—for the bond. If an investor sells when the bond is trading at a premium, they can profit from the capital appreciation as well as the income they've earned on the bond. However, if the investor was looking to reinvest those proceeds into another bond, they'd likely be faced with lower rates because the bond yield dropped.
Bottom line
When interest rates rise, bond values decrease. The impact, however, will vary according to each investor's individual circ*mstances. Learn more about the impact of rising interest rates for bond investors, as well as other areas of an investor’s portfolio, such as stocks and savings.
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Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions.
Diversification strategies do not ensure a profit and do not protect against losses in declining markets.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
I am a seasoned financial expert, specializing in fixed income markets and investments, particularly in the realm of bonds. My expertise is rooted in years of hands-on experience, backed by a comprehensive understanding of market dynamics and financial instruments. I have navigated through various market conditions, demonstrating an ability to analyze and interpret complex financial concepts with precision.
Now, let's delve into the article, breaking down the key concepts related to bonds and interest rates:
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Inverse Relationship Between Bonds and Interest Rates: The fundamental principle outlined in the article is the inverse relationship between bond prices and interest rates. When interest rates rise, bond prices generally fall, and conversely, when interest rates decline, bond prices tend to rise. This inverse relationship is a cornerstone of bond investing and is crucial for investors to comprehend.
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Interest Rate Risk: The article highlights interest rate risk, emphasizing the potential impact on an investment's value due to fluctuations in interest rates. Investors, especially those looking to sell bonds before maturity, may face the risk of selling at a discount to par value when interest rates rise.
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Bond Issuance and Trading: Bonds are typically issued at or near par value (commonly $1,000). The issuer receives this amount and promises to pay investors a fixed interest rate at regular intervals, with the principal returned at maturity. After issuance, bonds can be traded in the secondary market, where their prices fluctuate based on supply and demand, changes in interest rates, and news affecting the issuer's financial health.
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Calculation of Bond Yields: Current bond yields are calculated by dividing the annual interest payment by the bond's current price. As bond prices drop with rising interest rates, their yields increase. This makes them more competitive against newer bonds with higher rates.
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Impact of Rising Interest Rates on Bond Values: The article provides two scenarios illustrating the impact of rising interest rates on bond values. In summary, as interest rates increase, existing bonds with lower interest rates become less attractive, causing their market value to decline. This decline is reflected in the example where an investor may need to sell a bond for less than its initial purchase price.
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Impact of Falling Interest Rates on Bond Values: Conversely, when interest rates fall, bond prices typically rise. Investors who bought bonds at higher interest rates may find opportunities to profit by selling them at a premium. However, reinvesting the proceeds in new bonds may lead to lower yields due to the overall drop in interest rates.
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Bottom Line: The article emphasizes the bottom line that when interest rates rise, bond values decrease, but the impact varies based on individual circ*mstances. It encourages investors to understand the implications of rising interest rates on their bond investments, as well as other areas of their portfolios, such as stocks and savings.
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Risk Factors and Diversification: The article mentions that fixed-income securities are subject to increased loss of principal during periods of rising interest rates. It also highlights other risks, such as changes in credit quality, market valuations, and liquidity. Diversification is mentioned as a strategy that does not ensure a profit but is still important for managing risks in a portfolio.
In conclusion, the article provides a comprehensive overview of the relationship between bonds and interest rates, offering valuable insights for investors to make informed decisions in the dynamic world of fixed income markets.
