Why Are High Interest Rates Bad For Bonds?

I received a question from a client today that caught me a little off guard:

“Why do high interest make bond prices go down?”

While this is certainly an important topic and I was happy to explain it, I assumed that they would have known the answer.

Rather than continue to assume this is common knowledge, I wanted to write a post explaining the relationship between bond prices and interest rates.

Now, assuming we all know what a bond is, let’s use a quick example.

• The year is 2005. The 10-year Treasury bond is paying an interest rate of 4%, or $40 per year, per bond (this is well below the historical average, but that fact for the purposes of this discussion is irrelevant).

  Now, let’s jump to today, April 2012. The 10-year Treasury bond is paying about 2% interest, or $20 per year. Not so good, is it? About half as good, actually.

  Now, let’s say you purchased your bond in 2005. You paid your $1,000, and receive your $40 annually until 2015 when you expect to get your $1,000 back.

  But what if you wanted to sell your bond today?

  Do you think there would be a high demand for your 2005 bond today? You bet!

  Your 2005 bond is paying $40 of interest, while bonds issued today are only paying $20 of interest. You would have to be crazy to not want your 2005 bond!

  But wait a second, if that’s the case, why would someone pay $1,000 for a 2012 bond yielding 2%, when they can pay $1,000 for a 2005 bond yield 4%?

  They wouldn’t. No one would.

  That is why the 2005 bond paying $40 annual interest trades at a premium. What this means is if someone wanted to buy your 2005 bond today, they would pay MORE than $1,000.

  Note: While the calculation to determine how much more they would pay is a bit complicated, the way it would work is that the yield-to-maturity (YTM) of a bond purchase of a 2012 bond today would have to equal the YTM of purchasing your 2005 bond.

  So, with bond yields going down, the prices of the older bonds went up.

Now, when interest rates rise, the exact opposite occurs.

• Let’s say you buy a 10-year Treasury bond today. You receive your 2% interesting, or $20, each year for the next 10 years.

  But what happens when interest rates start going up?

  Let’s say in 2014, the 10-year treasury is back at 4%. Why would anyone want to buy your bond that only pays 2%?

  Again, they wouldn’t. To adjust for this, if you wanted to sell your bond you would have to sell it for less than $1,000, which is where the potential loss comes into play.

  That is why rising interest rates is bad for bonds. It makes the bonds you own today worth less in the future, because they are paying less interest than future bonds will be paying.

While a detailed discussion of how to reduce interest rate risk will take place in a future post, investment selection, risk diversification and laddering are all ways that you can reduce (but not eliminate) your exposure to interest rate risk.

Unfortunately a rising interest rate environment is often inevitable. However, with good planning and a watchful eye, it can be navigated with ease.

Note: Notice earlier that I said a rising interest rate environment creates a potential loss of value. This discussion applies only if you sell your bond prior to maturity. If you plan on holding your bonds until you receive the principal payment back, the market fluctuations in price really don’t matter. You will continue to receive the interest payment stated on the bond each year, at the end of which you will receive your face value.