Bonds can be tempting investments, because they’re thought to be less risky than stocks, because the bond issuer makes a promise to repay the bonds. A diversified portfolio with a mix of stocks and bonds can maximize your returns. It can also limit your risk exposure or even offset more risky investments
The way bond prices are calculated can be a little tricky. Even if you’re not likely to purchase single bonds for your portfolio, it's good to understand how they work and how their prices are calculated.
Why Bond Prices Change When Interest Rates Change
When interest rates rise, bond prices fall. When interest rates go down, bond prices increase. This inverse relationship can seem a little complex at first glance, but a chart can give you a better grasp of it.
Unlike stocks, bonds are a type of loan made by an investor. Often, the loan is to a company or government agency. In return, the investor receives fixed-rate interest income, usually semiannually, which remains the same despite how market interest rates might change.
Bonds compete against each other on the interest income they provide. When interest rates go up, new bonds come with a higher rate and provide more income. When rates go down, new bonds have a lower rate and aren’t as tempting as older bonds.
The bad news for bondholders is that fixed-rate bond issuers can’t increase their rates to the same level as the new issue bonds when rates go up. The older bond rates are locked in, based on the original terms.
As a result, the only way to increase competitiveness and attract new investors is to reduce the bond's price. As a result, the original bondholder has an asset that has decreased in price. It also doesn’t pay out as much as the new similar bonds on the market.
Loans are usually classified as short-, medium-, or long-term, based on how soon they repay the investors.
A Bond Example
Suppose you were to purchase a bond with a par value of $1,000 that has 10 years until you're repaid. On the date the bond matures, you’ll get the original $1,000 back.
The bond has a 3% coupon (or interest payment) rate, which means that it pays you $30 per year. If you’re paid every six months, you’ll receive $15 in coupon payments.
Suppose you want to sell your bond one year later, but the market interest rate has increased to 4%. Because buyers can now purchase a $1,000 bond with $20 six-month coupon payments, your $15 coupon payment doesn’t look so great.
- New bond: The buyer would receive $40 yearly for 10 years for a total of $400.
- Your bond: The buyer would receive $30 yearly for nine years for a total of $270.
To induce a buyer, you'll have to sell your bond at a discount. They would need to purchase your bond from you for $925 instead of the $1,000 you paid a year earlier. But how is this number decided upon?
How Much Will Bonds Fall When Interest Rates Rise?
It's rather complex to figure out roughly how much the discount might be, which takes into account these variables:
- The current interest rates
- How many coupon or interest payments you expect to receive until it matures
- How much each bond's coupon payment is
- The future value of the bond (face value)
For example, if you purchased a $1,000 Bond at 3% interest, which had 18 coupon payments remaining of $15 each, this is how an increasing interest rate environment would impact the market value of your bond.
|Today's Interest Rate||Market Value|
Here’s how a decreasing interest rate would impact the same bond:
|Today's Interest Rate||Market Value|
The term “duration” measures a bond’s sensitivity or volatility to market interest rate changes. It takes into account the coupon payments and the date the bond matures. A bond’s duration is expressed in terms of years and helps you compare different bonds or bond funds. The longer the duration of a bond, the more sensitive it is to interest-rate changes.
Rising Rates for Bond Funds vs. Individual Bonds
Single bonds can provide a steady income stream while maturing, and a guaranteed payment at maturity, but it can be tough to diversify your portfolio and limit your exposure to interest-rate risk with single bonds alone.
Interest rates are one of the leading factors in bond prices. The current price of any bond is based on several other factors that include the type of bond, market conditions, and duration.
A bond fund or bond ETF that invests in a large array of different bonds can help mitigate the risk accompanying interest-rate changes. For example, if you have just one bond with a duration of seven years and another with a duration of three years, the second bond helps mitigate your total risk exposure.
Now, consider that bond funds invest in many different types of bonds, magnifying that effect. With this diversity, bond funds tend to provide a better shield against rising interest rates than single bonds. They also lower default and call risk (when the borrower buys back the bond before the maturity date).
Should You Buy Bonds When Rates Are Rising?
Interest rates will always change, and no one can predict how they’ll change over time. Whether interest rates are rising or falling, it’s vital to consider your yield to maturity for any bond purchase and compare it with what you could get if you were to buy a new bond.
Bond pricing can be complex, so consider working with a financial advisor. They can help you run the numbers and figure out whether a bond purchase is a fit for your goals.
The Bottom Line
Bonds can be a vital part of a well-balanced portfolio. It helps to know how interest rates affect their prices so that you can adjust your holdings when rates change. Unless you enjoy doing the math, it might help to invest in bond mutual funds or ETFs, which can help reduce your risk, and leaves the math to professionals.
Frequently Asked Questions (FAQs)
Which types of bonds are the most sensitive to interest rate changes?
The longer a bond's term, the more sensitive it is to interest rate changes. Missing out on 0.25% of interest payments over a year isn't so bad, but missing out on 0.25% every year for decades will have significant opportunity costs. Those opportunity costs are priced into a bond's value every time the rate changes.
How does the Federal Reserve buying or selling bonds affect interest rates?
For most bondholders, interest rate changes happen to you, rather than being something you can cause to happen. However, the Federal Reserve has so much buying power that it can affect the broader bond market by buying or selling bonds. Buying bonds during economic downturns can suppress interest rates and make it easier to borrow money. Selling bonds during economic expansions can help keep the economy from overheating by suppressing bond prices and hiking rates.