Most investors know that bond prices will fall if interest rates rise. But what does that actually mean, and is there anything you can—or should—do to take advantage of changes in either prices or rates?
Given the Federal Reserve’s intention to raise interest rates—possibly by mid-2015—this is a good time to bring bond dynamics into focus. Numerous factors play into a bond’s price, including the current price for similar bonds, the interest the bond pays, the credit quality of the issuer, and more.
Let’s tease apart this web to better understand how bonds work and the interplay between changing interest rates and bond prices.
It might help to start with a quick acknowledgment that there is no single market interest rate. The Federal Reserve determines the federal funds rate—the interest rate on overnight lending between banks—which essentially sets a baseline rate for the shortest lending period with the highest credit quality of issuer.
Other interest rates then build on the fed funds rate depending on maturity (generally, higher rates for longer maturities) and credit risk (higher rates for lower quality).
Corporate bond rates use the interest rate on a Treasury bond of comparable maturity as a baseline, and then add what’s called a “risk premium”—compensation to the investor for tolerating a higher level of risk.
Now let’s consider the bond markets. New bonds are issued on the primary market, which individual investors can’t always access. Some issuance—for example, many corporate or high-yield bonds—is limited to big institutional investors. Others, like Treasury auctions, are open to individual investors as well. When you buy a new issue in the primary market, you pay the new-issue offering price, which is the same for all buyers.
Previously issued bonds are re-sold on the secondary market, which is more accessible to individual investors. This is where you’ll see price movements.
When market interest rates rise, for example, newly issued bonds tend to offer higher coupon payments. This makes the newer bonds more attractive than older bonds offering lower coupons. As a result, the prices of older bonds will go down because sellers need to offer prospective buyers some incentive to invest in a bond that pays a lower coupon than the going market rate.
The “see-saw” in the illustration above captures this effect. If you assume a par value of $1,000, and the interest rate of 5% rises to 5.5%, as in the example here, that higher rate is reflected in a commensurate 10% decline in the bond’s price to $900.
The reverse dynamic also holds true: When interest rates fall, newly issued bonds offer lower coupon payments and the prices of existing bonds tend to rise. In this example, the interest rate is now 0.5% lower (representing a 10% drop) and the bond price rises by 10% to $1,100.
When a bond is issued, you are lending the issuer—generally a government or corporation—$1,000 in exchange for a regular coupon payment and the repayment of the $1,000 when the bond matures. But in the meantime, in the public market, the price can fluctuate based on Fed policy, confidence in the economy, the going rate for similar bonds, the credit quality of the issuer and the maturity date.
So you might pay more for a premium bond because it will give you a higher coupon. Or you could pay less than the par value for a discount bond because its coupon is less than market rate. As you can see above, the prices of both premium and discount bonds converge toward par as maturity nears.
The term “fixed income” doesn’t come from the fact that people who buy bonds are on fixed incomes. It’s because bonds offer a “fixed” coupon payment that won’t grow or shrink for as long as you hold that bond.
If you sell a bond, it’s different from unloading a stock. With equities you’re typically dealing with a single price based on market value. With bonds, you have the price you paid versus what it’s now worth, plus the interest and coupon it will pay—and all that gets factored into the price when you buy or sell it.
If you’re worried about rates rising, you could try keeping the average maturity of your bond portfolio short to intermediate. By investing in bonds that mature in three to seven years, you’ll spend less time collecting coupons that are potentially below market rate.
You could also build a bond ladder. By buying bonds with varying maturities, you can reinvest at the higher market rate in a rising-rate environment. You can also use maturing bonds for cash flow.
But if you plan on holding your bond to maturity and your bond isn’t callable (meaning that it can’t be redeemed earlier than you expect), fluctuations in bond rates and prices shouldn’t keep you up at night. After all, you’ll get back the par value and you’ll collect your regular coupon payments as planned, assuming the issuer doesn’t default.
Call 877-566-7982 to talk with a Fixed Income Specialist about your bond portfolio.