This is a series of articles this month I am writing on Bonds. This is the 2nd article. I encourage you to read the first article which introduces you to bonds Do bonds have a place in my financial portfolio? before you read today’s article.
Last week, I introduced the topic of bonds for everyone. If the topic of bonds still captured your attention and you are here this week, lets talk about another topic that has always confused people including myself. Why do bonds move in the opposite direction of interest rates? I briefly touched on this in my earlier article on ‘Why should I care about what the central bank does’?. Today I want to explain the why and more importantly, why you should even care.
Lets first begin with one clear caveat. None of what I am about to tell you matters if you buy a bond at the time of issue and hold it until maturity of that bond. Remember the basics I highlighted in my article last week on ‘Do bonds have a place in my financial portfolio’?. A bond can be issued for a variety of terms. However, most people seek liquidity and hence want to buy and sell bonds (like they buy and sell stocks) in what is called the secondary market and not wait for 20 or 30 years for the bond to mature. For the average Joe like you and me, the secondary market is simply our trading account where we can buy and sell bonds every day. So, this article matters for practical purposes only if you are thinking of buying and selling bonds in the secondary market. Why is that? I will explain.
Bond definitions
Lets get some basic definitions on bonds.
- Face value / par value – this is the original value the bond is issued for.
- Term / maturity period – this is the term of the bond when it is first issued. Most bonds range from 1 to 30 years.
- Coupon rate / yield – this is the interest rate paid on the bond annually (typically paid out semi-annually). This is expressed as a % of the face value of the bond and will be paid until the maturity of the bond.
For the rest of this article, in order to explain the concepts I am going to use the following example. We are going to look at a bond that was issued for a face value of $1000 for 30 years maturity with a coupon rate of 2%.
What affects prices of bonds in the secondary market?
There are generally multiple factors that impact bond prices in the secondary market but the most important factor is interest rates. In the article ‘Why should I care about what the central bank does’?, I talk about why interest rates impact the economy in general. So, interest rates have a broader impact on asset prices directly and indirectly. When interest rates go up, cost of borrowing goes up for companies having an impact on earnings. The opposite is also true. So, interest rates have an indirect impact on stocks. With bonds, they tend to have a more direct impact.
Other factors also influence bond prices that include general market conditions as well as the credit worthiness of the bond issuer themselves.
Interest rate’s impact on bond prices
Lets continue with the example I stated earlier. There is a bond issued at a face value of $1000 for 2 years maturity with a 2% coupon rate thereby earning $20 each year, paid semi-annually . At that time, prevailing interest rates were 1% in the market. Now, lets examine how prevailing interest rates impact the price of the bond in the secondary market.
Scenario 1: Interest rates go up
Lets says the prevailing interest rate (determined by the central bank) went up from 1% to 2%. The person who bought the bond wants to sell it now in the secondary market. But what he encounters is that because interest rates have gone up, new bonds issued in the market now offer 3% coupon rate (higher than what he got when he originally bought the bond). So why would anyone want to buy a bond that only issues 2% in interest? In order to successfully sell the bond in the secondary market, he now needs to ensure that the bond buyer can get a 3% return. How does he do that? By reducing the sale value of the bond such that, the buyer can get 3% returns. So now the bond has to be priced at $666.67 in order for the $20 annual return to be the equivalent of 2% return.
Scenario 2: Interest rates go down
Lets say the prevailing interest rate went down from 1% to 0.5%. The person who bought the bond wants to sell it in the secondary market. But he sees that because interest rates have gone down, new bonds issued in the market now offer only 1% coupon rate (lower than what he originally bought it for). So, his bond is now more valuable because it offers a 2% coupon rate. What does he do? He says since my bond is now more valuable, you have to pay more to buy the bond to get the equivalent of a market coupon rate of 1%. So, he sells the bond for $2000 to make sure the return of $20 is equivalent to a 1% coupon rate.
Lets show all this in a table:
Scenario | Value of bond | Coupon rate | Return |
Original scenario | $ 1,000.00 (face value) | 2% | $ 20.00 |
Scenario 1: Interest rates went up | $ 666.67 | 3% | $ 20.00 |
Scenario 2: Interest rates went down | $ 2,000.00 | 1% | $ 20.00 |
As you can see, the bond issuer has fixed the return on the bond annually based on the original coupon rate. So you can see the coupon rate % changes with the prevailing interest rate thereby impacting the price/value of the bond. You also see that interest rates have an inverse relationship with bond prices in the market.
That’s great to understand the math. But what does this mean for me?
It really depends. It depends on your life situation and how much you depend on the income from bonds. If you are in the wealth accumulation phase, have many more years (10+) to retirement and simply buying some bonds as a small portion of your portfolio, then you don’t really need to be thinking about all this. If you are not someone who is buying and selling bonds on a regular basis, honestly this means nothing to you. Just sit back and enjoy the ride so to speak.
But if you are someone who in the wealth preservation phase and depend on the income from bonds, then you will be watching the yield on your bond portfolio closely. Then, you need to assess what is happening with interest rates in the economy. At the time of writing this article in Oct 2022, the US Fed is moving in an aggressive direction of increasing interest rates in order to tame inflation. This is playing havoc on bond prices in the market. But in my opinion, if you had a well-diversified portfolio, and were conservative with your retirement numbers, you are going to be just fine to ride out this phase.
Thank you for reading and hopefully this article gave you a bit more perspective on bonds. I wish you success in your personal finance journey!
Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.
