Interest Rate Changes Affect Price of Bonds
By Martin Krikorian
In 2018, The Federal Reserve increased interest rates 4 times. The 25 basis point increase on Dec. 19 increased the Fed funds rate of 2.25-2.5 percent to its highest level since the spring of 2008. Changing interest rates and the expectations about the future direction of interest rates can have a significant affect on the price of bonds.
The fact that bond prices and yields move in opposite directions is often confusing to investors. Over the years, many individuals who have attended our seminars and workshops will often ask, “If the Federal Reserve increases interest rates shouldn’t this be good for bonds?” “Why would higher interests rates cause bonds to go down?” “If interest rates go up, shouldn’t the price of bonds go up as well?”
The inverse relationship between interest rates and bond prices does seem to be somewhat illogical however it actually makes sense. For example, let’s say you paid $10,000 for a five-year bond that pays 4 percent annual interest. Six months later, interest rates go up and new bonds are now paying 5 percent. If you decided to sell your bond, do you think anyone would pay $10,000 for your 4 percent bond when they can pay $10,000 for a new bond paying 5 percent?
In order to entice someone to buy your bond you would have to sell it for less than $10,000. The reverse is also true. If six months later interest rates went down to 3 percent, your 4 percent bond now becomes more valuable to individuals interested in buying a bond. As a result, they may be willing to pay more than $10,000 to buy if from you.
Interest rate changes have a similar affect on bond funds as well. Most bond funds hold hundreds of individual bonds and are generally categorized by their duration rate. Duration is a measure of the sensitivity of a bond’s price to changes in interest rates. Duration incorporates a bond’s yield, coupon, maturity and other features into one number, expressed in years. As a general rule, for every percent increase or decrease in interest rates, a bond fund’s price (net asset value) will change by about the same percent in the opposite direction for every year of duration.
The accompanying chart illustrates the inverse relationship between a bond funds duration rate and changes in interest rates. For example, if interest rates increased by 1 percent, the price of a bond fund with an average duration of two years would fall by about 2 percent. If interest rates decreased by 1 percent, the bond funds price would go up about 2 percent. If interest rates increased by 2 percent, its price would fall about 4 percent. If interest rates decreased by 2 percent, the funds price would go up about 4 percent.
At Capital Wealth Management, we typically invest our clients’ bond fund holdings in a combination of short- and intermediate-term funds with an average duration of 3.7 years. Over the last 50 years, this portfolio has provided 85 percent of the return of longer-duration funds, while taking significantly less risk. This difference in risk was evident in 1994, 1999 and 2009.
During those years, long-term Treasury bonds with an average duration of 10 years lost a total of 29.6 percent. A portfolio consisting of short- and intermediate-term bonds, with an average duration of 3.5 years, had a combined loss of only 2.8 percent during the same three years.
Just as it is important to match the types of stocks with your personal financial goals and tolerance for risk, investors need to look at their bond portfolio in the same way. By knowing a bond fund’s duration, investors can seek to better structure the interest-rate sensitivity of their portfolio as it relates to overall risk and return objectives.
Martin Krikorian is president of Capital Wealth Management, a registered investment adviser providing “fee-only” investment management services located at 9 Billerica Road, Chelmsford. He is the author of the investment books, “10 Chapters to Having a Successful Investment Portfolio” and the “7 Steps to Becoming a Better Investor.” Martin can be reached at 978-244-9254, Capital Wealth Managements website; www.capitalwealthmngt.com , or via email at info@capitalwealthmngt.