Why Bonds Tank When Interest Rates Rise – And Why You Need To Understand

By glblguy

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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:

  1. 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.
  2. You might be tempted to invest in long-term bonds right now to earn a bit more interest.
  3. If you do that, you will get your clock cleaned when (not if) interest rates rise.

Here’s why.

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
Year 1 $100,000 5% $5000
Year 2 ? 1% $5000
Year 3 ? 10% $5000

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
Year 1 $100,000 5% $5000
Year 2 $500,000 1% $5000
Year 3 ? 10% $5000

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


13 Responses (including trackbacks) to “Why Bonds Tank When Interest Rates Rise – And Why You Need To Understand”

  1. DDFD at DivorcedDadFrugalDad.com Says:

    Nice job explaining the inverse relationship between price and yield . . .

  2. Nate @ Debt-free Scholar Says:

    Great explanation…but what if interest rates don’t rise? Nobody, and I mean nobody, knows what the economy is going to do, but the smartest people think that it will continue tanking.

    Go Peter Schiff!

    Thanks,
    Nate

  3. ABCs of Investing Says:

    Interesting – my Monday post on ABC is on the exact same topic!

    Your pricing example is a bit off however – it assumes that the interest rates will stay low for the duration of the bond. It also ignores the discount rate of future payments which is a big factor in pricing long term bonds

  4. Jim Palmer Says:

    Hi there, I don’t usually weigh in on articles and I certainly appreciate the ones that I have read on this website. The reason for my input is that while the inverse relationship between price and yield is correct in this article, in actuality it appears (if I understand the scenario) that it is vastly overstated.

    If you buy could buy an ~30yr Treasury today that has a 5% coupon and you can pay par ($100,000) for it, thereby earning a 5% coupon and yield, THEN, one year from now market rates on that part of the yield curve have fallen to 1%, then your bond would be worth (only) $194,000 – not $500,00 as was mentioned in the article. If, one year later, market rates had risen to 10% the bond referenced above would be worth only ~$54,000. So, the up rate scenario was pretty much right. I ran the analysis on a Bloomberg business computer. Just thought you’d want to know.

    Again, thanks for all you are doing to educate, encourage, and inform!

  5. Neal Frankle Says:

    Thanks Divorced Dad.

    Nate, the main goal of this is to explain the relationship between bonds and rates. I agree with you. I don’t know what is going to happen to rates but I think my last warning is worth considering.

    ABC’s, good point. Clearly, the article only talks about the impact of rates on bond values and there are other considerations. My point was to explain that relationship in a way readers would feel comfortable with. But I agree, other factors will impact values (but all things being equal – rates have the greatest potential to impact values.)

    Jim, again, I really appreciate the feedback. Certainly, the maturity date will have a huge impact on the values as well as other factors. You and ABC are 100%. Again, the idea was to answer the question of how rates will impact values. I isolated one variable and did so hypothetically to illustrate. I should have pointed that out and I really thank you for your constructive comments.

  6. The Geared Investor Says:

    Great article!

    Bonds are kind of the dark and scary tunnel that most new and small investors won’t go down. This explanation of the inverse relationship between interest and bond earnings is clear and easy to understand for all investors. @Jim Palmer: Thanks for running the numbers to give us a more precise idea of what our investment would become.

    Great job!

  7. Neal Frankle Says:

    Thanks for the kind remarks Geared!

  8. Brian Says:

    I think this is interesting and something I definitely didn’t have any idea about before, but I still have a question. Why would I buy your bond for $500,000 if I’m only going to get the $100,000 principal at the end? Unless I get that $5,000 a year in interest for 80 years I think I would come out behind. It would seem that I’m missing something in my understanding.

  9. surveillance camera systems Says:

    A great explanation on that side!. Actually, if it analyzed carefully, if an individual decided to loan, he is now expecting for an interest on the loan he actual made, so he would not be able to pay for it as an actual loan he first done. Bonds have it’s per value upon sold. Other companies assigned risk ratings to bonds, therefore some corporation doesn’t know in advance what price are you wiling to take advance payment.

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