What’s the relationship between bonds and interest rates?
In general, rising interest rates hurt bond prices while falling interest rates drive bond prices up. In other words, there’s an inverse relationship between bonds and interest rates. Why is this the case?
First, let’s understand what we mean by interest rates. For a plain vanilla bond, the coupon rate—the rate that determines how much the bond owner is paid—doesn’t change. But the general level of interest rates in the economy changes every day. These changing rates affect the value of outstanding bonds. Changing interest rates don’t mean that much for investors who buy and hold their bonds until maturity—after all, the corporation or government that issued the bond is contractually obligated to pay out the coupons at par value. But for those selling their positions beforehand, fluctuating interest rates can trigger capital gains or losses that ultimately affect a bond’s resale value.
How are bond prices determined?
To understand how bonds are priced, take a hypothetical 5-year, 4% coupon bond as an example. If the general market interest rate rises from 4% to 5%, yields on newly issued bonds will reflect the higher rate. Naturally, this renders existing 4% bonds less attractive. The lower-yielding 4% bond would therefore decrease in price and would have to sell at a discount to par to induce an investor to purchase it.
On the flipside, if the market interest rate falls from 4% to 3%, the 4% coupon bond would increase in price since it’s more attractive than new bonds being issued, so it would sell at a premium to par. Buyers would have to bid up the price of this security just enough so that sellers are adequately compensated for foregoing higher yields on their bonds.
How sensitive are bonds to interest rates?
To gauge a bond price’s sensitivity to interest rates, investors use a measure called duration. Duration measures how much a bond’s price will change given a change in market interest rates. The higher a bond’s duration, the more sensitive a bond is to interest rate changes.
Time to maturity, coupon rate, and fixed-income structure are some of the major factors that influence a bond’s sensitivity to interest-rate fluctuations.
Time to maturity
Longer-term bonds generally have a higher duration than their shorter-term peers. This is because bonds are fixed-income instruments that promise a steady stream of future interest payments. Because the future is unknown, the longer the time to maturity, the more uncertainty faced by the investor. In other words, the longer a bondholder commits to a fixed rate, the riskier it becomes to hold it..
Time to maturity becomes more ambiguous when coupon payments are factored in. Bonds with lower coupons are generally more sensitive to interest rates than their higher-yielding counterparts. Because they receive a smaller share of payments early on in their payment schedules, their present values depend more on their larger payments at maturity. Conversely, higher-coupon bonds will receive proportionally higher payments before maturity, making them less reliant on the repayment of their capital at end of the term.
In the extreme case, a zero-coupon bond (one that pays no coupons) will have the highest interest-rate sensitivity. Because there are no interest payments before maturity, the average time to maturity in this case is equal to the bond’s actual maturity date.
Interest-rate sensitivity also varies according to fixed-income category. Not all bonds are cut from the same cloth, and some are more sensitive to interest rate changes than others.
Floating rate bonds – Floating rate notes are generally less sensitive to interest-rate changes because their interest payments are adjusted at regular intervals according to prevailing market rates. Since their coupons change to reflect current market rates, their bond prices are less sensitive to interest rate changes.
High-yield bonds – High-yield bonds are generally less sensitive to rising rates for several reasons. First, many high-yield bonds have floating rates, and as mentioned, floating-rate bonds are less sensitive to interest-rate changes. But in addition, high-yield bonds have a much larger element of default risk baked into them, which is much less prevalent than with investment-grade corporate bonds and government bonds. Therefore, these bonds are much more sensitive to the underlying company’s financial performance and the health of the general economy, leaving less room for the bond price to be sensitive to interest rates.
Bonds with embedded features – Bonds with embedded features, such as callable bonds, give the issuer the option to buy back their bonds, limiting a bondholder’s capital gains if interest rates fall. Because these bonds generally have higher yields, there are some cases where they may be less sensitive to interest-rate fluctuations.
Should you buy bonds when interest rates are rising?
Rising rates can put a damper on your bond portfolio, but this doesn’t mean you shouldn’t buy bonds. To put things into perspective, rising rates can impact everything from consumer debt loads to business spending, housing affordability, and even the economy at large.
Thankfully, bondholders can cushion the impact of rising rates by investing across fixed-income categories, maturities, and even geographic regions. Because bonds also tend to offer capital preservation, income generation, and the potential for capital appreciation, they’ve always been a stalwart of well-diversified portfolios.
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