Rising Interest Rates — Bad for Bonds?

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by David Novak

While just about all investors are familiar with the volatility of the
stock market, I find that not as many fully understand the risks that come with
investing in bonds. Many predict that interest rates will soon be rising from an
extended period of being at historically low levels, and that this will hurt fixed
income investments. Why is a rising interest rate environment bad for bonds?

To explain the relationship between changes in interest rates and bond prices,
let’s use an example. Assume you purchased a five-year, $10,000 bond at
face value that was paying a 7 percent coupon rate. Now suppose interest rates
fall, thereby causing newly issued bonds similar to the one you bought to offer
only a 6 percent coupon rate. If you were looking to sell your 7 percent bond
before it matures, since it is now more attractive than the 6 percent bonds that
reflect current yields, you will be able to get more than par value. In fact, you
will be able to sell your 7 percent bond at $10,421, a nice premium to the par value
that you paid. Buying your 7 percent bond at $10,421 nets an investor the
identical return to maturity that would be achieved by buying the 6 percent bond
for $10,000.

On the other hand, suppose interest rates rise, thereby causing bonds similar
to yours to offer an 8 percent coupon rate. If you were looking to sell your
7 percent bond, since it is no longer as attractive as newly issued bonds, you
would need to discount the price of your bond to the point where the buyer would
achieve the same total return being offered by the bond paying 8 percent. It
turns out that this price where the return is equivalent is $9,601, approximately a
4 percent discount to the par value that you paid.

In a very general sense, the longer a bond has until maturity, the more its
price is affected by a change in interest rates. Other factors, such as the bond’s
credit quality, can also be a factor.

It is important to note that if a bond is held to maturity, as long as the issuer—
whether it is a corporation, government, or municipality—is solvent, you will
receive your original $10,000 back (in addition to the $700 in interest payments
that you received each year).

Next month we will explore how interest rate changes can affect bond
mutual funds.

David Novak, CFP® is a Certified Financial PlannerTM at Novak & Powell Financial Services in Pinellas County. Please note: he is not an attorney and this article should not be construed as one offering legal advice. For information about investment decisions and financial planning,
contact him at (727) 451-3440.

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