2004-05-13 / Business & Finance

The Relationship Between Bond Prices And Interest Rates

The Relationship Between Bond Prices And Interest Rates

It was disappointing to read an article in the New York Times Business Section regarding a nationwide survey of bond investors. The survey, conducted by Harris Interactive, interviewed 1,541 U.S. investors, and found the following results:

1. Nearly two-thirds of those surveyed did not understand that rising interest rates could have a negative impact on bond values.

2. 57% said that they expected in-terest rates to rise in the next two years.

3. Only 35% said they believed that the value of bond investments declined when interest rates rose.

4. 27% believed that bond prices rose along with interest rates, while the rest said that either they didn’t know, or that bond prices remained stable when rates rose.

All of these results demonstrate that most investors don’t have a clue as to the relationship between bond prices and interest rates. This is especially disturbing because so many people have put their money into bonds or bond funds during the past couple of years as the stock market tanked.

Most bond investors have had very good total returns during the past couple of years, but it’s obvious that they really don’t know why. Total return is a combination of income plus capital gain divided by the initial investment. The double-digit returns that bonds have provided for the past few years are due mainly to capital gains as bond prices have increased.

Why did bond prices go up? Be-cause of the sharp decline in interest rates that has occurred since 2001, The Harris survey shows that most bond investors don’t realize that the relatio-nship between bond prices and interest rates is an "inverse" one. That means when rates go down, bond prices go up Conversely, when rates go up, bond prices go down. With interest rates in the U.S. at forty-year lows, the likelihood is much greater that, in the fu-ture, they’re going to go up rather than down. That means bond prices will likely fall over the next couple of years, and total returns from bonds may be zero or even negative.

Maybe an example will show more clearly just how this relationship be-tween bond prices and interest rates works. Let’s assume that an investor purchased a ten-year government bond three years ago for a price of $1,000, and that the interest rate on the bond was 5%, or $50.64 per year in interest.

Now, three years later, even though the interest rate on similar bonds has declined to 3.5% ($35 per year), our investor is feeling pretty good about his decision. Why? Because the bond purchased three years ago has increased in price to $1,092, reflecting the de-cline in market interest rates.

So, not only has our investor been receiving $50 per year in interest, but he has also seen the price of his bond increase by $92—a pretty good return by any measure.

But, what’s going to happen if rates turn around and go up during the next few years (as the majority of the survey respondents believed)? Then bond prices will fall, perhaps dramatically.

For example, two years from now, our investor’s original bond will have five years remaining until maturity. The bond will continue to pay $50 per year in interest. But if interest rates increase to 6%, then the price of the bond will decline to about $957. Our investor’s previous capital gain of $92 will disappear, replaced by a paper capital loss of $43.

Remember that these various gains and losses would only be realized if the investor were to sell the bond in the marketplace. If they continue to hold the bond until it matures, then the redemption price will be $ 1,000 and there will be no capital gain or loss.

Term to maturity is another important factor in determining the price movements of a bond. The longer the maturity, the greater the price swings. If we had used a thirty-year bond in our previous example, the price swings would have been even greater in both directions.

What to do? The first thing to do is to not immediately unload your bond portfolio. Why? 1) Because no one knows just when interest rates will move up. 2) Bonds continue to pay dividends that will offset any price loss. 3) Using concepts from the Nobel Prize-winning "Modem Port-folio Theory," you want assets in your portfolio that have a negative covariance. In plain English this means that you want one to zig while the other zags.

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