January 30, 2018 Investing 0 comment

The effects of changing interest rates on previously issued bonds

The effects of changing interest rates on previously issued bonds

 

The recent level of interest rates for the 10 year and 30 year US Treasury bonds, indicate we may be ending a 25 year plus downtrend in those rates. Time will tell if that is the case or not. I do think it is time to explain what the change in interest does to the market price of a previously issued bond.

The general effect of a change in rates with all other factors being constant is that bond prices tend to move in the opposite direction of the direction of change in the interest rate. The easiest way illustrate this is with an example of two bonds that have the same maturity date. The bonds are issued one year apart from one another by the same issuer and the interest has changed by 1% in that period of time.

Date Year 1     Year 2    
  Bond price Yield to Maturity Years to Maturity Bond Price Yield to Maturity Years to Maturity
Bond 1

4% coupon

100 4% 10 92.96 5% 9
             
Bond 2

5% Coupon

      100 5% 9

As a buyer I would not pay the same price for a 4% bond as I would a 5% bond. The coupon on the 4% bond is fixed for the life of the bond so the only adjustment mechanism is the price of the bond. The rule of thumb used to calculate how your bond price will change with a change in interest rates is the (change in rates) * (the duration) of the bond. Duration is weighted average time for a bondholder to receive the cash flows from the bond. Higher coupon bonds have a shorter duration and lower coupon bonds have longer a duration when compared to their maturity dates. Zero coupon bonds have a duration equal their maturity date.

As an investor you have several options when considering a rising rate environment:

  1. Avoid fixed income securities.
  2. Accept the decline in price of fixed income securities and wait until maturity when the full value is returned.
  3. Shorten your duration in your fixed income portfolio.
  4. Invest in variable coupon rate fixed income securities.

Each of these options has a trade-off. Knowing the duration of your portfolio is usually the starting point in this analysis.