Why Bonds Tank When Interest Rates Rise – And Why You Need To Understand
It can be really intimidating to talk to a professional adviser sometimes. They know the lingo and you may not. And of all the confusing financial concepts, the relationship between bonds and interest rates can be uber-confusing.
It’s critical to understand this relationship for a few reasons:
- I don’t want to be the first to bring this to your attention…but….eh….in case you haven’t noticed, interest rates are pretty close to zero.
- You might be tempted to invest in long-term bonds right now to earn a bit more interest.
- If you do that, you will get your clock cleaned when (not if) interest rates rise.
Bonds go up in value as interest rates decline. That’s good. But unfortunately, the inverse is also true. As rates go up, the value of the bond declines. The reason for this is that bonds are valued based on the income they produce. Read that again. It’s very important.
Look at the table below to understand this relationship.
|Year||Initial Investment/Value||Market Rate||Interest Received|
For our example, assume you invest $100,000 in year 1. The market rate of interest is 5% so you get $5000. This amount never changes – unless the company who issued the bonds goes broke – in which case you won’t get a cent.
So, in year 1, you’ll receive $5000. And you’ll get $5000 in annual interest as long as you own the bond or until it matures. Once the bond matures, you’ll get your $100,000 back – as long as the company who issued the bonds doesn’t go belly up.
In year 2, interest rates plummet. The current market rate drops to 1%. Of course you still get your $5000 interest check. It doesn’t go down. So what happens to the value of your investment?
YOU JUST MADE A KILLING! Your $100,000 investment is now worth $500,000! Why? Well…you tell me. Remember, you still get your $5000 because you invested last year. If another investor comes along and wants to earn $5000 in interest in year 2, how much will that person have to invest? (Remember…..interest rates fell to 1%.) If you said that the new investor needs to pony up $500,000 to earn $5000 you are right. So, in year 2 if Ms. Investor comes to you and wants to buy your bond, you won’t sell it for less than $500,000 because you know that she would have to invest $500,000 anywhere else in order to replicate the $5000 income. Kabish?
Now consider, if you will… year 3. Interest rates skyrocket to 10%.
|Year||Value||Market Rate||Interest Received|
Now how much will I have to invest in order to earn $5000 in year 3? The answer is $50,000. I can invest $50,000 at 10% and earn $5000. If you want to sell your bond in year 3 the most you’ll get is $50,000. Why would I pay you a nickel over $50,000 to buy your bond? I can generate the $5000 by investing only $50,000 elsewhere when rates are 10%.
It doesn’t matter what you paid for your bond. It only matters how much interest your bond generates.
So if you make the mistake of buying long-term bonds when interests rates are low (like now), the value of your bonds will decline rapidly when rates go back up.
It is true that if you hold your bonds to maturity, the fluctuations really don’t matter. At maturity, you get the face value of the bonds. In this case, you’d get the $100,000.
However, if you believe, as I do, that rates are going to go up over the next few years, it makes more sense to stay with short term bonds now and buy long-term bonds only once the rates have already increased.
Does it matter to you that bond values fluctuate? Are you prepared to wait it out? How long?
This was a guest article by Neal Frankle, CFP who provides straight forward advice on how to increase your net-worth at his blog Wealth Pilgrim. If you you’ve enjoyed this article, consider subscribing to his RSS feed.
Photo by: subewl