Oran Hall What interest rate changes mean for bonds
A bond is a certificate issued by a government or corporation as evidence that it has borrowed a sum of money on which it promises to pay a specified amount of interest to the lender for a specified period and to repay the principal at maturity.
Although the borrower repays the full sum borrowed when the instrument matures, the price of a bond and its value may change during the course of its life.
There are two main factors that may affect the price and value of a bond. One is its quality, and the other is the movement of interest rates. The quality of a bond may change when the borrower encounters challenges in meeting contractual interest payments and when it appears that it may find it difficult to repay the principal sum borrowed.
More generally, though, interest -rate movements cause the price of bonds to rise or fall. Their price tends to fall when interest rates increase and rise when they fall. In the financial world, this is described as there being an inverse relationship between bond prices and interest rate movements.
Investors who hold their bonds to maturity have nothing to fear as they will get back their investment in full at maturity. The main problem for them is that as the general level of prices in the economy increases, referred to as inflation, the purchasing power of the principal declines, so the investor becomes unable to buy the same basket of goods and services with the same nominal amount of money.
Investors in bonds also face the risk of default, which occurs when the issuer fails to make payments within the specified period.
When the investor elects to sell the instrument before it matures, there is a possibility of losing or gaining capital on the transaction. When the level of interest rates increases and the price of the bond falls, the seller loses some principal as a result.
On the other hand, when the seller disposes of the instrument in a situation in which the level of interest rates declines, the price of the bond increases, thus enabling the seller to make a capital gain.
The primary reason that the price of these instruments changes, with changes in interest rates, is that buyers on the secondary market – the market for securities after they are first issued – invest to get returns that are in line with those that are prevailing in the market at the time that they are investing.
If an investor was buying a bond with a coupon rate – that stated on the bond – of 5.0 per cent at a time when the yield to maturity of such an instrument was 6.0 per cent, the price would have to be lowered to allow this to happen. On the other hand, the price would be increased if the desired yield to maturity was 4.0 per cent.
Interest-rate changes do not affect all bonds to the same degree. Those with a higher coupon rate generally experience smaller price changes. The same is true for those with a shorter term to maturity.
There is wisdom in spreading out the maturities of bonds in a portfolio, especially one owned by a retired person. While it is true that the yields will tend to vary, it reduces the risk of capital loss if the need arises to sell unexpectedly.
Although bond prices generally change with changes in interest rates, interest payments remain the same for fixed rate bonds during the life of the instrument.
In the case of variable rate bonds, however, the situation is different. The price and value of the instrument tend not to change meaningfully or at all, but the interest changes as it is based on a formula expressed as a set level of percentage points, say 3.0 per cent, above the yield on a particular instrument, such as a treasury bill, the return on which is determined by the market periodically.
Mutual fund and unit trust funds, which include fixed rate bonds, are not exempt from fluctuations in their values when interest rates change, even when the interest they generate is re-invested, as is the general practice. Thus, bond funds and balanced funds, to a lesser extent, may see a decline in their values due to higher interest rates, or an increase due to lower interest rates.
So ordinary shares do have company. Bonds are also capable of causing the value of portfolios to increase or decrease though not necessarily as violently as stocks. Further, if high interest rates persist, they could cause the values of fixed rate bonds purchased prior to the increase in interest rates to remain below their purchase price for an uncomfortable length of time.
The opposite is true if interest rates decrease. Eventually, bond prices move towards par as the term to maturity shortens so that the investor receives the face value of the instrument at maturity.
Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel. Email: finviser.jm@gmail.com