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 now exceeds $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 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—at a discount to par value or below the price you purchased the bond at. 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 bond holders at maturity. Once a bond is issued, they 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’s an example that helps explain the relationship between bonds and interest rates:
Let’s assume you’ve purchased a newly issued bond for $1000 from XYZ company with a 10-year maturity, a coupon of 2.0%, and a par value (think face value) of $1000. You’ll receive annual interest payments of $20 ($1000 par value x 2.0% coupon = $20) and you’ll receive your principal of $1000 at maturity in 10 years. Now, let’s say interest rates increase and now XYZ corporation has to pay 3.00% to attract investors for that $1,000; why would anyone pay $1000 for the bond with a coupon of 2.0% when they can buy a bond from the same company with a coupon of 3.0%? If you wanted to sell it before maturity, you would have sell at a price lower than the $1000 you originally paid based on the new prevailing rate in the market of the newly issued bonds being offered at the higher coupon rate of 3.00%.
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 par value of $1000. 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. Don’t forget interest rates aren’t the only thing that can impact bond prices. Investors need to understand that "there will be price variations as they hold the bond," says Craig Laffman, Director, Fixed Income Trading and Syndicate, TD Ameritrade. Laffman also pointed out several potential factors fixed income investors should consider: 1) who is the issuer, 2) what is the credit risk, and 3) what is the interest rate and how does it compare to similar securities in the marketplace. Always make sure to fully research any investment you’re considering.
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 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, income and capital gains, has become one of the most popular bond investment strategies.
- 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.
As with any investment decision, make sure you do your research. 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. 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.
And remember 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. "Even the most active traders have a long-term investment portfolio," he notes. It’s important to stay on top of your investments to ensure they are working to help you pursue your financial goals.
Check out TD Ameritrade’s Fixed-Income Investments page to learn more about why bonds play an important part in planning a diversified portfolio.