Interest Rates Up, Bond Prices Down

By Jon Flynn

Please note this article was written in June 2007. All interest rates and relevant facts referenced in this article are from that point and time.

The yield on the 10-year Treasury note jumped as high as 5.32% last week, soaring to a five-year peak in interest rates. For many people who invest in bonds, this type of spike can spell trouble. Why? Because there is an inverse relationship between the price of bonds and the direction of interest rates. Imagine a seesaw with interest rates on sitting on one end of the board and bond prices sitting on the other end.  As interest rates go up, bond prices come down, and vice versa. What creates this phenomenon? Let’s take a look….

Consider an investor who had purchased a zero coupon bond that will mature in a year. The bond is currently selling in the bond market for a price of $960 per bond.  When the bond matures this investor will receive the face value of $1,000 per bond. That’s a $40 increase which works out to a 4.16% yield to maturity calculated as follows, (($1,000-$960 / $960)).

Now imagine a world where interest rates have gone up.  Where investors can find one-year zero coupon bonds that yield 7.5%.  Please keep in mind that this rate of return is for illustrative purposes only.  That’s quite a spike up from the low 4.16% rate that our bond owner had previously locked into for a year. 

What if this investor suddenly needed money and couldn’t wait until the maturity date and had to sell their bond early?  Could they sell the bond for the $960 they had originally paid?   Since interest rates have gone up, and investors can find better paying bonds, the answer is no.  The bond will be worth less. 

How much would the seller have to come down in price to make the bond attractive to a new buyer? The fair price is the price where when adjusted for current interest rates the buyer would receive the current market rate of 7.5%. This means the bond would have to sell for $930 (($1,000 - $930 / $930= 7.5%)) to be attractive. Unfortunately if the investor has to sell at $930, they’ll lose $30 ($960-$930) or a 3.1% ($30/$960).  Now, lets say this unfortunate investor didn’t own just one bond but owned ten of the same bond. The total loss ten bonds would be $300 (10 x $30).

A loss of $300 would certainly come as a bad surprise but the loss could have been even worse if the investor had owned a bond with a much longer maturity.  This is because long-term bonds are even more sensitive to interest rate moves than short-term bonds.  Also, it's important to note that a bond with a higher interest rate will carry a higher risk of default, such as corporate bonds.

Where will interest rates go from here? Who knows for sure, everybody has an opinion, but really it’s just anybody’s guess.  So it’s important to review your portfolio to determine the degree of sensitivity it may have to interest rate moves.  Keep in mind that this seesaw type action can have a devastating effect on your savings if you need to cash in early.

Everybody situation is different and arriving at solutions can get complicated.  So always consult with financial, legal, and tax professionals before making any decisions.

 

 

Jon Flynn is a Certified Financial Planner ^TM and owner of Flynn Financial in Eynon. He is a Representative of Securities America, Inc., Member FINRA/SIPC and of Securities America Advisors, Inc. Flynn Financial and Securities America are unaffiliated.   Mr. Flynn can be reached at 570-876-5015.