How Bonds are Valued and React to Interest Rate Changes

How Bonds are Valued and React to Interest Rate Changes

Investing a portion of your portfolio in bonds is a standard practice for anyone over the age of 30. As you get closer to retirement you want less volatility because your portfolio has less time to react to drastic market changes. Stock holdings can lose 25% or more of their value in a short period of time while bond holdings don’t normally have such drastic swings in value. If that big drop happens three years before your retirement you’ll be stuck hoping for a dramatic rebound.

Yet investing in bonds does not eliminate all risk from your portfolio. Bonds have a different type of risk for you to be concerned about: interest rate risk.

How Bonds are Valued and React to Interest Rate Changes 1

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How Bonds are Valued

Investors in bonds aren’t investing in equity or ownership in a company. Instead, bondholders loan money to an entity like a municipal government or private company in return for a known interest rate for a specific period of time. A company might issue a 10 year bond with a 6% interest rate. If you invested $10,000 you would be paid $600 per year for the life of the bond and at the end of the term you would receive your principal — also known as the full face value — back as well.

The value of a bond is tied up in its two variables:

  • the term (how long until the bondholder is paid the full face value back) and
  • the interest rate (how much the bondholder is compensated until the end of the term).

Initial bond values are set by the institutions that underwrite the bonds, but the value of the bond is not set in stone.

How Bonds React to Interest Rate Changes

Since bond values are impacted by interest rates, any changes to the interest rate environment will impact the value of the bond. If you hold a bond until its maturity and are satisfied with the interest rate you are receiving, any changes in the value of the bond in the marketplace doesn’t matter to you. However, if you are interested in selling your bond before its maturity then interest rate changes can be positive or negative depending on the direction they move.

For example, let’s assume you are holding a $5,000 bond with an 8% interest rate. You will receive $400 per year until the bond matures and you are paid the full face value of the bond. If you are happy with an 8% return and hold the bond to maturity, any changes to its value doesn’t impact you.

However, let’s now assume you do not want to hold the bond to maturity, but the market is now offering a similar bond with a 9% interest rate. If an investor had to choose between a $5,000 bond at 8% and a $5,000 bond at 9% they would be crazy to take your bond with the lower interest rate because interest rates have risen in the marketplace. To offset this you are forced to discount your bond so the return the investor would receive is equivalent to the 9% bond. If you discount the price of the bond from $5,000 to something lower, the bondholder is still paid the full face value when the bond matures, and the discount helps offset the difference in the two interest rates.

An 8% interest rate is equivalent to 88.89% of a 9% interest rate (to get this number just divide 8% by 9%). In this example you would need to discount your $5,000 bond at 8% to 88.89% of the $5,000 value — $4,444.44 — for the investor that buys your bond to get an equivalent return to the other bond he could have purchased. The 8% interest rate still holds for the bond and the new investor will still receive $400 ($5,000 x 8%) until the bond matures. However, that $400 payment on the $4,444.44 price he paid is equivalent ($400 / $4,444.44) to a 9% interest rate.

Risks of Investing in Bonds in a Low Interest Rate Environment

Now understanding that bond values can be significantly impacted by interest rate changes you need to be aware of the risks of investing in bonds in a low interest rate environment.

Locked in to Low Rates

The first problem with investing in bonds when interest rates are low is you’re giving up money for a very low return. You are going to get a better rate than what you would find in savings accounts and money market accounts, but the returns are still going to be low.

What’s the Fix?: The only way to fix this problem is to not invest in low interest rate bonds. Not all bonds have extremely low values, but the safer ones do. You can increase the yield of your bond by decreasing the safety of the bond. Junk bonds or high-yield corporate bonds are two options to help boost the return with a trade off of more risk of default.

Losing to Inflation

Not only are you locked into low rates, but those rates can be so low that if inflation is higher than the return you receive on the bond your cash is actually losing value even though it is invested. If your bond pays 3% and inflation is 4%, you aren’t even keeping pace and the value of the cash will go down. (And this isn’t even taking tax rates into consideration.)

What’s the Fix?: The only way to keep pace with inflation is to use Treasury Inflation Protected Securities (or TIPS). These bonds pay a small yield while also guaranteeing the principal will keep pace with inflation so that when the TIPS mature the spending power of what was invested is unchanged.

Which Directions are Interest Rates Likely to Move?

To make matters even worse you have to consider that if rates are extremely low the likelihood of them getting even lower (and thus increasing the value of your bond) is extremely unlikely. Likewise there is a much greater chance that interest rates rise which will lower the value of your bond. Not only will you be stuck with low rates until maturity, but if you did want to sell the bond you would have to discount the price of the bond to compensate for higher rates in the marketplace.

What’s the Fix?:¬†Accept that interest rate risk is part of owning bonds. You can invest in short term bonds rather than long term to avoid some of the interest rate risk, but there is no way to completely eliminate that risk.

2 thoughts on “How Bonds are Valued and React to Interest Rate Changes”

  1. So now it’s 2012 – I’ve read that interest rates are low, so is now NOT a good time to buy bonds? That’s what I understood, but I’m not sure if the interest rates only matter when you redeem your bonds. Thanks for any help.

  2. @Roderick – In general, it’s not a good time to buy, but I still buy them as part of my asset allocation strategy. Interest rate matters when you sell your bonds at any time before maturity, and when you redeem them when they mature.

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