Audio Version: Let Me Hear It!
There are many relationships that we know to be true but don’t fully understand. For example, we know that exercise releases endorphins, smoking causes cancer, and the moon causes waves but how? As you might suspect, we aren’t prepared to explain any of these connections but we can explain a very well-known but less understood financial correlation between interest rates and bonds. What many investors know is that an increase in interest rates makes bond prices go down. This week, we will explain why that is so…
Think of a bond as an IOU from a corporation, municipality, or government. In exchange for your investment, you will receive interest (“coupon”) for a set period of time (“term”) until your investment is returned to you (“maturity”).
In its attempt to control the supply of money, the U.S. Federal Reserve (the “Fed”) controls the Fed Funds Rate, which is the rate that determines all other rates, including the base rate for bond interest (known as the risk-free rate). Decisions by the Fed to change rates act like a domino, pushing down or pulling up all other rates, accordingly.
The interest rate paid on a bond is also determined by risk. The primary risk of bond investing is default risk – the risk that you don’t get paid back (interest and/or principal). The greater the risk of default, the higher the coupon payment will have to be to get investors to buy a bond.
Put simply, bond prices go down when something better comes along. Consider this: you buy a 5-year, 3% coupon bond for $1,000. If interest rates rise a year after your purchase, your bond essentially becomes less desirable – both to you and to others. In order to participate in the now higher-paying bond options, you could sell your 3% bond to buy, say, a 4% bond instead, but to entice a buyer to choose your 3% bond over the 4% he or she could get elsewhere, you will need to reduce the price of your bond. Remember, you stood to receive 3% per year from the bond, plus $1,000 at maturity. In this example, a buyer would be willing to pay about $963 for your bond, which would provide the 4% return he or she is expecting (3% coupon plus the difference between $963 and $1,000).
Since a lot can happen over longer periods of time, the risk of something better coming along is greater with longer-term bonds. Accordingly, the longer a bond’s maturity, the more sensitive its price will be to changes in interest rates.