My mom’s neighbor called me this week to ask about the “bond crisis” as he had read a headline to that effect. I have shared my concerns over the general business media in the past and this is yet another example of why I feel the headlines don’t tell the full story (and perhaps are geared to extremes to encourage “clicks”). While the turn of phrase “bond crisis” is perhaps a bit exaggerated, it is important to understand the impact that rising rates have on bond prices and their total returns over time.
There is an inverse relationship between interest rate and bond prices – meaning that as on goes up, the other goes down. Why is this the case? I always find it’s best to consider an example.
Let’s say you buy a ten-year $100 bond from me today and I offer you a 4% annual interest rate. Every year, you will earn $4 on that bond and have my contractual promise to repay the $100 at the end of the 10 years.
Now, fast forward a week. Interest rates have moved in the marketplace and I now need to be willing to offer lenders 5% on that same 10 year $100 bond (meaning any new lenders will earn $5 every year over the course of the 10 year term).
Which is the better of these two options for lenders/investors? The higher/5% interest rate of course.
So what happens to the value of the 4% bond I sold you last week now that rates are 5%? Its value has gone down due to interest rates having gone up. Why? A 4% interest stream over 10 years is less valuable than a 5% interest stream over 10 years. So if you wanted or needed to sell someone the 4% bond you’re holding in a 5% rate world, the price would need to be discounted to adjust for the lower interest stream over its life (making it “equal” in total return to their alternative option of just buying the 5% bond).
Total Return of a Bond
Another concept to understand when it comes to bonds is total return. This total return is comprised of the change in fair value (over the time you hold the bond) plus the income earned (this is the contractual rate of interest paid on the face value of the bond).
A few years ago, when interest rates were near zero, there was very little income that could be earned as the stated rates of interest were hovering around near zero at some maturities. Further, there was a lot of negative potential in fair values as rates were highly likely to rise from their historic lows as we emerged from the pandemic (and as you learned above, values fall as rates rise).
Today, the absolute level of rates is much higher (approaching 5% on the 10 year treasury – and even higher on riskier credits). As a result, while there can still be negative movements in fair values (if rates move higher from here), the income earned (from the stated/contractual coupon) does help offset those fair value declines. And if rate increase decline (as they are doing this week), those fair value changes will move the other way and add to total returns.
Impact of Holding to Maturity
Remember that bonds are a contractual promise to repay in a given period of time, plus a stated rate of interest. As a bond investor, if you hold individual fixed income securities, you have the ability to hold the bond to maturity and collect the initial value of the bond plus the interest stream, regardless of what rates do during the bond term (provided the borrower is of good credit and able to pay you back).
As a result, it is fair to say that if you hold the bond until maturity, you don’t suffer any realized loss in principal (ie: the face value invested) that can be caused by a change in rates during the bond’s term.
However, at any given point over the term of your bond, if rates go higher, you are experiencing a loss in fair value of your holding (as you could be earning more in another bond) and if rates go lower, you are experiencing a gain in the fair value of your holding. These moves have a real economic impact and can result in an opportunity cost (or benefit) to you over the term of the bond. Your custodian will record fixed income holdings at fair value so you can monitor the change and act accordingly.
As you can see, there are a lot of complexities when it comes to fixed income/bond investing. If you have other questions, hit reply and send them my way!
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