Understand the relationship between rates and bonds, regardless of whether you hold bonds
Learn how bonds can provide consistent income with the potential for profit
Consider diversifying your portfolio with bonds, which are generally low risk
As an investor, it’s important to have an understanding of the relationship between bonds and interest rates. After all, the bond market is by far the largest securities market in the world and is larger than $100 trillion in size, according to PIMCO.
Depending on your financial goals, you might not be focused on how interest rates can impact bond prices, but should still understand the relationship between the two. Keep in mind, bonds can be an important component of a diversified portfolio and they’ll likely become a more important part of your portfolio as you get closer to retirement. So what does happen to bond prices when interest rates rise?
Bonds and interest rates have an inverse relationship. This means, when interest rates rise, bond prices typically decline and when interest rates decline, bond prices will typically rise. This is a fundamental principle of bond investing which results in investor exposure to interest rate risk—the risk that an investment’s value will fluctuate due to changes in interest rates.
Understanding the relationship between interest rates and bond prices can be a little confusing at first, but it’s important to know so you can make informed investment decisions when considering bonds and other fixed income products.
If you’re holding the bond to maturity, interest rate risk isn’t as big of a concern to you as it would be for someone that might need to sell the bond prior to maturity and may be forced to sell at a discount to par value or below the price where you purchased the bond.
Most bonds are issued at par value, usually $1,000. The issuer receives this money when the bonds are first offered and, in return, promises to pay investors a stated interest rate with the intent of returning that initial investment of $1,000 back to bondholders at maturity.
Once a bond is issued, it can be traded in secondary markets causing prices to fluctuate depending on supply and demand, changes in interest rates and news that an issuer may not be able to honor the obligations of the bond.
Here are examples of two bonds with the same par value but different interest rates:
- You buy a bond for $1,000 with a 10-year maturity and a coupon of 2.0%. The par value would be $1,000. You’ll receive annual interest payments of $20. After 10 years, you’ll receive your principal of $1,000, with $200 in interest.Interest rates increased and the same $1,000 bond now pays 3.0%. The par value on that bond is $1,000. You’ll receive annual interest payments of $30. After 10 years, you’ll receive your principal of $1,000, with $300 in interest.
So, the first bond then becomes less valuable because it is producing less income. Essentially, its market value declines. If you wanted to sell the first bond before the 10-year term ends, you would likely have to sell it for less than $1,000. You would lose money on the principal, and you would not receive the remaining interest payments. In this case, the rise in interest rates pushed the market value of the bond lower.
What Happens to Bonds When Interest Rates Fall?
When interest rates fall, bond prices typically rise and there may be an opportunity to profit if you sell the bond prior to maturity. Let’s assume you bought the same bond in the example above with a 10-year maturity, a coupon of 2.0%, and purchased it at a par value of $1,000.
But, this time interest rates fall to 1%. Now, the coupon on your bond is more attractive than current market rates so investors would be willing to pay a premium—above par value—for your bond. If you sell when the bond is trading at a premium, you can profit from the capital appreciation as well as the income you’ve earned on the bond.
FIGURE 1: BOND MATURITY. For illustrative purposes only. Bonds are subject to default risk; research your choices carefully.
Portfolio Planning With Bonds
Fixed-income investments, like corporate, municipals, brokered CDs (certificates of deposit) and government bonds, are important components of any diversified portfolio. Here are some reasons you may choose to consider bonds for your portfolio:
- Capital preservation. Barring a credit event like a bankruptcy, bonds repay the principal at a specified date, or maturity. This makes bonds attractive to investors who may be looking for a product with a lower risk of losing capital, as opposed to a more volatile product such as equities. Generating income. Most bonds provide investors with “fixed” income (the interest payments) on a set schedule—usually on a quarterly, biannual, or annual basis. Investors can then choose to spend or reinvest the interest payments they receive depending on their needs. Helping to generate income streams is one of the reasons why bonds and other fixed-income investments can play an important part of an investment strategy for those planning for and living in retirement.Opportunity to profit. Bond prices can rise for several reasons, like a drop in interest rates or an improvement in the financial situation of the issuer. Investors can profit by selling bonds after they have risen in price—adding to the bond’s total return, or the combination of income and capital appreciation. If held to maturity however, the investor will miss out on any price gains over the life of the bond since bond prices typically decline back to its par value the closer it gets to maturity and will be repaid at face value. Investing for total return—both income and capital gains—has become a widely used bond investment strategy.Diversification. Although asset allocation and diversification cannot guarantee against investment losses, including bonds in a diversified investment portfolio can help mitigate a measure of risk from being overly exposed to one type of asset, like equities or commodities. Different asset classes perform better in different environments, and adding bonds to a portfolio may help provide more consistent returns.
What you should invest in is ultimately determined by your financial goals, risk tolerance and investment strategy. Retirees investing in bonds and fixed income might be more focused on capital preservation and generating income than younger investors with a higher risk tolerance and time horizon.
Either way, it’s never a bad idea to brush up on the basics. Having a better understanding of different types of investments helps make sure you’re not overlooking an important asset class in your portfolio.
Once you’ve made your investment decisions, and put your portfolio to work, make sure to schedule regular check-ins. “With long-term portfolios, sometimes investors set it and forget it, but that can lead to bad things,” says JJ Kinahan Chief Market Strategist at TD Ameritrade. It’s important to stay on top of your investments to ensure they are working to help you achieve your financial goals.