Most somewhat experienced investors know that interest rates have an inverse relationship to bond prices. This means when interest rates rise, bond prices go down. Why is that?
First, I will go over how a bond works for those of you that don’t know. A bond is a debt instrument for a corporation or a government entity. An individual buys most types of bonds for what is called their par value (usually $1,000) from the issuing company, and the company pays the individual interest on that debt, usually semi-annually. This payment is called the coupon payment. Every bond also has a maturity date, which is the date that the company must pay back the borrowed amount, or par value, of the bond to the individual who owns it. Think of buying a bond like making an interest only loan to a corporation for a set period of time, after which they must pay you back the principal. Bonds, like stocks, can be bought and sold in a secondary market. The price of that bond, after the original sale, can vary up or down from its par value. The coupon payment is set at the time the bond is issued based on the credit rating of the company, the current interest rates, and the maturity date of the bond. The value of the bond in the secondary market is based on the time until it matures, the coupon payment, and current interest rates.
So how are bonds valued? Bonds are valued by looking at the future cash flows that a bond will provide the owner, and discounting them back to today’s dollars. The basic theory behind discounting is that a dollar today is worth more than a dollar tomorrow, because if you invest that dollar at today’s interest rates, the value of that dollar will increase. Therefore, the higher the current interest rates are, the more that dollar will increase in value over time. When interest rates rise, the rate at which you discount the future coupon payments from the bond increases, making them less valuable in today’s dollars, and the price of the bond falls. If you are confused, don’t worry, it is a difficult subject to understand.
Another way to think about this is what are the alternatives to the bond you currently own? Let’s say you just bought a bond with a 10 year maturity with a coupon payment of 4%. A year from now, interest rates have risen by 1%, and the same company issues another bond with 10 year maturity but the coupon payment is 5%. Which one would you rather own? Of course you would rather have the new bond with the 5% coupon. So why not just sell your bond with the 4% coupon and buy the one with the 5% coupon? That seems like it would be so easy, but there is a catch. As soon as that interest rate rose 1%, the price of the 4% bond dropped to compensate for that. So that bond that you paid $1000 can now be sold for less than $1000, but if you want the 5% coupon bond, guess what you have to pay for it? That’s right, $1000.
It almost seems unfair, but there is a silver lining here. The 4% bond that you already own will actually increase in value the closer you get to its maturity date, even if interest rates are rising. Why would that happen? Well, when that bond matures, you are going to get your original $1000 back, making it worth exactly $1000 on the date of maturity, as long as the company is financially solvent and planning on paying you back!