How do changes in interest rates affect bond prices?
Typically, bond prices and interest rates move in opposite directions. This means that when interest rates rise, bond prices tend to fall, and conversely, when interest rates decline, bond prices tend to rise.
Here’s why:
Suppose you invest $10,000 in a 10-year U.S. Treasury bond with a 3% yield. That interest rate is fixed, even as prevailing interest rates change with economic conditions—especially the rate of inflation. After five years, you decide to sell the bond, but interest rates have risen and similar new bonds are now paying 4%. Obviously, no one wants to pay $10,000 for a bond yielding 3% when a higher-yielding bond costs the same. So the bond’s value has decreased.
When interest rates decrease, the reverse happens. If interest rates had fallen and new Treasury bonds with similar maturities were yielding 2%, you could most likely sell your 3% bond for more than your purchase price.
When evaluating your bond related investments an important piece of information is a statistic known as “duration.” In finance, the duration of a financial asset that consists of fixed cash flows, like a bond, is the weighted average of the times until those fixed cash flows are received.
Duration also measures the price sensitivity to yield, the percentage change in price for a parallel shift in yields. Simply said, the longer the duration, the more sensitive a bond is to changes in rates.
Interest rate risk can be simplified by the following statement: when interest rates rise, bond prices fall; conversely, when rates decline, bond prices rise. Therefore, the longer the time to a bond's maturity, the greater its interest rate risk.
Many investors often put a high percentage of their portfolios in bonds for income or to hopefully generate more stable types of returns. This holds especially true when they are very worried about the economy or other financial issues, or after they have taken a beating in stocks. Unfortunately, in a rising interest rate environment, that logic could present problems.
In my next article, we will discuss what a prudent investor should do!
Email me, Julia M. Carlson, your questions at financial.freedom@lpl.com or call 541-574-6464
Julia Carlson is a registered Principal with, and securities are offered through, LPL Financial. Member FINRA/SIPC.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
