While many investors could correctly answer a question about the direction of bond prices when interest rates rise, understanding such a relationship at an intuitive level in an ever-changing market place can sometimes be elusive.
One way to better conceptualize and understand the relationship between bond prices and interest rates is to think of price and yield as a see-saw.
When Yields Go Up Prices Go Down
On one end of the see-saw is the market price of a bond or bond fund/ETF. The other end of the see-saw is the yield. When the interest rate (yield) side of the see-saw rises, the market price end of the see-saw goes down.
Let’s say you bought a five-year bond for $1,000 and a 2% coupon (interest rate). At this point the see-saw is completely balanced with the $1,000 face value on one end and the 2% coupon (yield) on the other (for this example, we will ignore the slight difference between the coupon and the yield to maturity at the outset). Now, if interest rates, in general, were to rise, the 2% coupon on your bond is not so attractive to another investor. After all, why should they pay $1,000 for your bond that pays 2%, when they can buy a brand new bond issue that is paying the new rate of 3.0%? As a result, the market price of your bond would fall below $1,000 to the point that the buyer would get a yield of 3% on the investment even though bond is still paying the same 2% coupon. In this case (for simplicity assuming no time has elapsed) the market price would be about $954. The bond would be said to be trading at a discount, as the price end of the see-saw dipped below 1,000 and the effective yield rose above the 2% coupon to an effective yield of 3%. The yield went up, and the price went down.
Don’t Confuse Coupon and Yield
It is important to not confuse the coupon rate with the yield. The coupon is a fixed amount that will be paid based on the original face value of the bond. The yield is what we call the return to the investor when they pay the market price to purchase the bond. Thus a $1,000 face value bond with five years to maturity and a coupon of 2%, purchased at discount for $948 actually yields the investor 3%. Again, when the yield goes up the price goes down.
On the flip side, if interest rates were to fall, the existing 2% coupon would be more valuable, and thus the $1,000 face value of the bond would trade with a premium at roughly $1,048, which would yield the new investor 1%. When the yield goes down, the market price of the bond goes up.
The Longer the Time to Maturity, the Greater the Impact of a Change in Interest Rates
Another thing to understand is that a change in interest rates (yields) will not affect the price of all bonds the same. The most important factor in determining how much the price will change is the maturity date (time remaining) of the bond. The closer the bond is to maturing, the less a change in yield will affect the market price.
Returning to the see-saw example, you can think of a short term bond as being located near the center or fulcrum of the see-saw while a long term bond sits near the end of the see-saw.
The longer the maturity (further away from the fulcrum) the greater the impact of a change in overall yields (movement of the see-saw) on the market price of the bond.
Thus one of the considerations an investor must make is how much exposure to interest rate risk they are willing to take (particularly in an environment where there is little room for rates to go down, but a lot of room to increase).
To lessen interest rate risk, an investor can use intermediate or shorter-term maturities, whether they be individual bond or bond funds and ETFs. The trade-off for such a move, however, is that the shorter the maturity- the lower the coupon (and yield). Many investors feel the interest rate risk is higher with bond funds or ETFs when compared to holding individual bonds. This is based on the fact that funds and ETFs have no maturity; thus, the net asset value is continually changing, like a stock mutual fund. An individual bond, on the other hand, can be bought and held until maturity so that the investor does not have to worry about the rise and fall of the market value of the bond but receives the stated face value. As discussed in the post Bond Ladders vs Bond Funds, however, sometimes the real world of investing can thwart such plans.
As with most things related to investing, what is right for one investor is not necessarily the best solution for another. Personal preferences and comfort levels are a crucial part of an investment allocation plan and dramatically reduces the chance that an otherwise good strategy will be abandoned when the going gets tough.
Understanding at an intuitive level concepts such as the price and yield see-saw can help investors determine an appropriate investment strategy and allocation given their scenario.
DISCLAIMER: Nothing in this article should be construed as a personal recommendation or advice. Nor should anything in this article be construed as an offer, or a solicitation of an offer, to sell or buy any investment security. Barnhart Investment Advisory clients and principals may hold positions in any securities mentioned in this article. Investors should conduct their own due diligence and seek the advice of a financial and/or investment professional before making any investment decisions.