Last week we covered some of the basic characteristics and terminology of bonds. Understanding that a bond is simply a loan to be repaid at a stated interest rate over a fixed period of time lends a certain determinacy to their analysis. One factor that can be readily examined is the impact of changes in interest rates. Unlike for most other investments, the expected change in price of a bond due to rate movements can be assessed quite precisely.
Bond prices and interest rates are inversely related, much like a seesaw. Press down on interest rates and bond prices rise; hike rates and bond prices decline. Other things equal, the relationship can be expressed with mathematical precision.
Chris Hopkins of Barnett & Co.A bond represents a series of equal cash flows (interest payments) and a fixed final payment (the return of principal or par value at maturity). Payments are determined at issuance according to the coupon interest rate, the market rate on the issue date.
Consider a bond issued today by IBM that carries a 4 percent coupon and matures in 2025. An investor would pay $1,000 and receive 4 percent or $40 per year in interest for 10 years, and then be repaid the $1,000 face value. If the market rate remained constant at 4 percent for the entire 10 years, the value of the bond would also maintain its $1,000 value throughout.
What if interest rates decline to 3 percent one year from now? With 9 more years of $40 payments, the bond would be more valuable to an investor who could only receive $30 from a brand new bond. With the aid of a bond calculator (available on numerous websites as well), we can readily compute the value of the old bond at the new lower rate: $1,078. So a bond buyer could spend $1,000 to buy a $30 stream of payments, or alternatively $1,078 for a $40 annual stream (again, all thing equal).
Conversely, if market rates rise to 5 percent in a year, the value of our IBM bond would decline to $929 since the old $40 payments would fall short of what a new bond would produce.
A discussion of this relationship between rates and bond prices is more relevant today than at any time in a generation. Most investors have only witnessed declining interest rates, and therefore very positive returns in their bond investments. In 1981, the previous peak in the rate cycle, U.S. 10-year Treasury bonds sported a 16 percent yield. As in our first example above, rates subsequently plummeted; the 10-year Treasury bond today yields a paltry 2.1 percent. The last 34 years have been very kind to bond investors.
Going forward, probably not so much. Once the cycle starts back higher, the value of outstanding bonds will decline (like our second example). For relatively short maturities, investors can hold out for their principal value to recover toward par. But longer-dated bonds are more sensitive to rate increases, imposing greater price declines on unsuspecting holders and presenting a Hobson's choice of selling at a loss, or holding to maturity but accepting a below-market interest payment for the duration. And bear in mind that bonds inside of mutual funds or ETFs are rarely held to maturity, virtually assuring that some investors will be confronted with at least some permanent losses under a regime of sustained rate increases.
Bonds are appropriate for diversified portfolios, providing income and some protection against volatility during periods of uncertainty. But investors should understand the characteristics of their bond holdings and gauge the impact of interest rate changes before those changes have occurred. After all, the Fed might actually move someday.
Christopher A. Hopkins, CFA, is vice president and portfolio manager for Barnett & Co. in Chattanooga.