We are approaching Christmas and most of us are now shopping in “light speed mode”. Unfortunately, Santa won’t give us many gifts with regards to fixed income. Rates are currently at their lowest since the legend of Saint-Nicolas was first told and things probably are not going to be better in a few months. Can rates go lower? That is not the problem. In fact, I would be more worried if interest rates start rising. If you were bitten hard enough by the stock market in 2008 and decided to switch your investments towards bonds, you will see that your portfolio can suffer negative results as well. Why? Because bond values drop as interest rates goes up.
Why do Bond Prices Go Down When Interest Rates Rise?
This is an interesting concept and most people don’t realize the impact of rising interest rates on bonds unless they have live through it: when interest rate goes up, the value of existing bonds goes down. Some people may be tempted to think that bond values would go up as more people would want to buy them due to a higher interest rate, but it doesn’t work like this:
Let’s say that you have paid $1,000 for a municipal bond giving 4% over the next five years. Once you have paid the amount of $1,000, you receive a transaction confirmation and you see the bond value in your investment portfolio.
During the next five years, you will receive the amount of $20 every six months ($40 per year, so 4% of $1,000) and at the end of the 5 years, you will get your $1,000 back. If interest rate haven’t changed, your bond value in your portfolio will stay at $1,000.
What if the interest rate goes down?
If interest rates go down, this means that the same municipality can offer bonds with a lower interest rate. Instead of paying investors 4%, they may be able to pay only 3% for 5 years. So they will continue to issue bonds at $1,000 but will offer 3% interest on them, so $15 every 6 months.
Even though your bond matures in 5 years, you always have the possibility to sell it on the market. This is why bond values fluctuate over time.
Therefore, if you have a bond paying 4% and the same bond is now offering 3%, do you think yours worth more? Yup, you are right. The value (originally set at $1,000) is now worth more money. In order to compensate for the fact that your bond is paying 4% and the others are paying 3%, your bond value will increase from $1,000 in order to compensate for the “extra” $5 you receive each semester.
So if rates go down 1 year after you have purchased your bond, you still have $160 to receive in interest before maturity while the new bonds will offer only $120 for the same period. While the calculation is a bit more complex as rates never change exactly on interest payout dates, your bonds value will more likely increase by $40 (so $1,040) to compensate the lower interest. So if you sell it on the secondary market, the investor won’t get more in his pocket compared to a new bond at 3% because he will purchase the bond at $1,040 and get $1,000 back in 4 years… while he will receive $160 in interest during this period.
This is why your bond values will temporarily increase. I wrote “temporarily” because if you keep your bond, you will still receive $1,000 at the end of the term.
What if the interest rate goes up?
We are currently living the lowest interest rate period of all time. Therefore, chances are that the interest rates will go up in the near term, right?
Based on the above mentioned example, if interest rates go up, bond values will go down to match the new interest rate. Therefore, your bond value of $1,000 will drop at $975 for example because your bond is not giving a high interest rate compared to what is being offered right now.
If you sell it at $975, the buyer will receive a lower interest rate but will receive $1,000 back at maturity. This is how the overall yield will be balanced.
How does bond value drop affect your portfolio?
If you have bonds in your investment portfolio, chances are that you will see their value going down during 2010 and 2011 (while the interest rate will go up). However, if you keep them until they mature, you will still get your money back. You just have to keep in mind that you will see negative returns during 1 to 2 years.
If you have bonds in your mutual funds, you will see the same variation. The only difference is that you don’t see which bonds you hold and what their value is since your money is pooled with others. Nonetheless, the result will be the same: you will suffer from 1 to 2 years of negative returns before your bond mutual funds bounce back upon bonds maturity.
Final Thought:
If you have bonds in your portfolio, be prepared to see their value tank once the interest rates start to rise. However, you don’t have to worry and keep the very same investing strategy. You will get your money back upon their maturities. In the end, you just have to be patient!
Author: Mike.
Image source: gilbertofilho
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