Friday, October 9, 2015

A Question on Bonds and Rates

Hello Mr. Helms,

On your podcast you said that bonds lose money when interest rates rise. I thought bonds always paid the same interest. How does that change?

You're right about the interest. The vast majority of bonds pay a fixed cash-flow during their life and return a fixed amount at maturity. Since those two things don't change, the only way markets can react to supply and demand for those payments is the price of the bond itself.

I've never done a good job explaining this. Rates and prices work inversely. It's like trying to cut your hair in the mirror.

But I've got a good example that seems to work:

Let's say you loan me $1,000. I agree to pay the owner $50 a year for the next 10 years and return the principal with the last payment -- basically a 10-year 5% bond.

A year later, you need to sell your bond. Unfortunately, the going rate for 9-year bonds has gone from $50 a year (5%) to $100 a year (10%). Nobody is going to pay you $1,000 for your bond when they can get twice the income for the same investment.

If you want to sell, you'll have to discount the price until the combination of the profit the new buyer makes in 9 years -- plus my $50 a year -- equals a 10% return. In the business that's called yield-to-maturity. Some of it is interest. Some is the gain (or loss) at payoff.

With a bond-price calculator I entered $50 a year for 9 years with $1,000 at the end at a yield-to-maturity of 10% and got a price of $712 for your bond. If rates had gone down, you could expect a profit instead.

And it isn't just your bond. Bonds are priced constantly in world markets whether they are for sale or not. That's why the values can change on your statement even with no activity.

As a rule, the longer an owner has to wait for his principal, the wider the price fluctuations because of market uncertainty. Lower-quality bonds usually fluctuate more than high-quality bonds for the same reason.

So the best answer to your question is that yields rise because bond prices fall. The new owner's increased yield comes from the old owner's wallet.

I used an extreme example to show the process. Rates doubling in a single year would be a disaster for the bond market and probably every other financial market in the bargain. Right now rates are historically low but don't appear to be in any hurry to go up either.

And advisors can't legally borrow money from clients. -SH

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.