What Happens to Bonds
When Interest Rates Change?
Interest rates and bond prices have an inverse relationship-rates and prices are like opposite ends of a seesaw - when one rises, the other must fall.
It's all about math...
Any bond with a fixed coupon (periodic interest payment) becomes less attractive if other similar bonds are available with higher coupons. To make a lower coupon bond comparable to higher coupon bonds, the price will need to be reduced.
A simple example
A ten-year bond with a $10,000 face value and 6% coupon would pay $600 interest annually. At the end of the ten year period (maturity), you would receive back $10,000. If you pay $10,000 to buy the bond and collect all payments, the yield-to-maturity (annualized return for the life of the bond) would be 6%.
In comparison, buyers would not be willing to pay the same $10,000 price for a similar bond with a 5% coupon (all else equal, 6% beats 5%). A price of around $9,250 would be required for the buyer to earn the same 6% return. The lower price makes up for the smaller interest payments that will be collected.
How does this impact you?
A few things to note regarding changes in interest rates:
- Cash flows don't change: Interest payments and maturity value remain the same regardless of price fluctuation
- Yield-to-maturity (YTM) doesn't change* after a bond is purchased: The return is based on purchase price and anticipated cash flows - interim price changes aren't part of the equation.
* For the mathematically inclined, it should be noted that the YTM does assume that all interest payments can be reinvested at the same constant rate. This may not be an accurate assumption.
- Rising rates have a negative impact in the short-run and a positive impact in the long-run: Bond prices adjust downward when rates rise (see the example above), but cash flows will be reinvested at higher rates. Longer-term, higher interest payments are beneficial.
- A "bear market" for bonds is not the same as for stocks: Stocks periodically have "bear markets" generally defined as declines of 20% or more. The broad U.S. bond market has never experienced a decline anywhere close to that magnitude. For bonds, a bear market is often considered to be simply a period of negative returns, and even those circumstances are infrequent.
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