Why do bond values go down when interest rates go up?

[QofQuimica]

I don't really understand why a bond bought now when interest rates are low will be worth less when interest rates go up. Is it because no one will want to buy the older bond since they can get newer bonds at the higher interest rate? But why should that affect the principal of bonds already sold?

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[krl7044]

I don't really understand why a bond bought now when interest rates are low will be worth less when interest rates go up. Is it because no one will want to buy the older bond since they can get newer bonds at the higher interest rate? But why should that affect the principal of bonds already sold?

Good question. Bonds are a little tricky, but all you have to think about is that by the time your bond matures you will be paid a very predictable amount that is fixed when you buy the bond. That amount does not change, regardless of what the market does. So if the price of the bond goes up, the yield goes down to compensate so that your interest payments remain constant.

From Investopedia:
"Measuring Return With Yield
Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield.

Let's demonstrate this with an example. If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). Pretty simple stuff. But if the price goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200)."

Things get trickier when you buy bonds that are not at par (either above or below), or that might have call provisions, but all in all, savers want HIGH yield and LOW prices, so we all should welcome bond prices crashing so that we can scoop up CDs and individual municipal bonds at low prices and high yield.

 

[QofQuimica]

Ok, is yield the same as interest rate? To use their example looking at it from the opposite direction, if my interest rate is 1%, then on a $1000 bond, I would make $10. If the interest rate increases to 2%, they're still only going to pay me $10, so now my bond is worth $500. That would explain why the principal is now less because the interest rate is higher. Is that right? And at the end, do I get my full $1000 back even though the interest rate went up?

 

[solitarius]

Would suggest you do some research on "present discounted value", a crucial concept in finance and bonds. Change in interest rate changes the current value of your bond b/c investors can get a higher or lower income stream for the same amount invested. This matters if you are buying the bond, and once bought, it becomes relevant if you need to sell it because you need the money for something else.

If you hold your bond to maturity, you will get the interest payments and principal at the end assuming there is no default.

 

[krl7044]

Ok, is yield the same as interest rate? To use their example looking at it from the opposite direction, if my interest rate is 1%, then on a $1000 bond, I would make $10. If the interest rate increases to 2%, they're still only going to pay me $10, so now my bond is worth $500. That would explain why the principal is now less because the interest rate is higher. Is that right? And at the end, do I get my full $1000 back even though the interest rate went up?

Yes. At maturity you will get your bond at par (even though you bought it at a higher or lower price initially). Most bonds are rarely priced at par, so that's where the additional complication is. So the good thing about bonds is that you get a very predictable cash flow, and your principal is relatively safe if you don't sell until maturity. But before purchasing a bond it is possible (and necessary) to analyze the bond's parameters to make sure that you are getting a fair price vs. other bonds of the same type. Municipal bonds for example are perfect for those in high tax brackets, and using individual bonds it is possible to get much higher yield than using bond funds (and at a lower cost).

By the way, dividend-paying stocks also act like bonds. If S&P's price falls dramatically, the yield on it rises. This is why a buy and hold portfolio has to be heavily slanted towards dividend-paying stocks, so that when the market is down you'll get a constant stream of dividends (and over the long term, S&P's return is as much as 40% due to dividends - and this be as much as 100% during prolonged crashes such as the one from 2000 to 2012).

 

[QofQuimica]

I don't understand that whole last paragraph (about dividend-paying stocks behaving like bonds) at all, but one thing at a time. Anyone have any suggestions for good books that explain these concepts?

 

[krl7044]

So a stock that pays a dividend acts like a stock (growth) and like a bond (an investment that pays dividends) at the same time. The only thing is that stock dividends are not guaranteed, so you don't get a predictable cash flow.

Would this work? I think parts of it are rather complex, but I'm sure you'll get something out of it.

http://www.google.com/url?sa=t&rct=...mECF7wJ-98klT3Q&bvm=bv.72185853,d.cGE&cad=rja

 

[QofQuimica]

So a stock that pays a dividend acts like a stock (growth) and like a bond (an investment that pays dividends) at the same time. The only thing is that stock dividends are not guaranteed, so you don't get a predictable cash flow.

Would this work? I think parts of it are rather complex, but I'm sure you'll get something out of it.

http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=9&ved=0CFMQFjAI&url=http://pages.stern.nyu.edu/~adamodar/pdfiles/invfables/ch2new.pdf&ei=OYjZU7OUKdimyATet4L4CA&usg=AFQjCNEaPGPrv24Yl8XUGMZlqy-6e23D1g&sig2=zNMFyzamECF7wJ-98klT3Q&bvm=bv.72185853,d.cGE&cad=rja

Ok, yes, thank you, after reading the vignette, I now understand why you're saying dividend paying stocks are like bonds (just with no guarantee). But I still don't really understand why both of them lose value when interest rates rise. Even that chapter you posted mentions that the bond's price can increase when interest rates go down, but it doesn't really explain why that happens.

 

[krl7044]

Ok, yes, thank you, after reading the vignette, I now understand why you're saying dividend paying stocks are like bonds (just with no guarantee). But I still don't really understand why both of them lose value when interest rates rise. Even that chapter you posted mentions that the bond's price can increase when interest rates go down, but it doesn't really explain why that happens.

Try this one:
http://www.investopedia.com/ask/answers/04/031904.asp

This does not happen automatically, and there are certainly dislocations and overshoots/undershoots. Imagine you have a CD that yields 2%. Suppose the interest jumps. You can now get a 4% CD. What are you going to do? Probably dump the first CD for a small penalty and buy a 4% CD. When you have a bond and try to sell a bond that yields 2% to buy a 4% one, you can imagine that everyone is trying to do that, so prices on that bond are pushed down, and yield is pushed up. Ideally, the price of the bond will go down (as everyone is selling it) until it yields exactly 4%, just as the newly issued bonds are. This is just how the market corrects the imbalances.

 

[QofQuimica]

Try this one:
http://www.investopedia.com/ask/answers/04/031904.asp

This does not happen automatically, and there are certainly dislocations and overshoots/undershoots. Imagine you have a CD that yields 2%. Suppose the interest jumps. You can now get a 4% CD. What are you going to do? Probably dump the first CD for a small penalty and buy a 4% CD. When you have a bond and try to sell a bond that yields 2% to buy a 4% one, you can imagine that everyone is trying to do that, so prices on that bond are pushed down, and yield is pushed up. Ideally, the price of the bond will go down (as everyone is selling it) until it yields exactly 4%, just as the newly issued bonds are. This is just how the market corrects the imbalances.

That does help, thank you. I think where I was confused is that I was assuming that once you buy a bond, you hold it until maturity. If you do that, then what other people are doing is kind of moot because you already paid whatever the price was to buy the bond. So if the interest rate goes down and you keep the bond, you still paid the lower price for your bond. But I guess the point is that most people in that situation would try to sell the bond because now its price is higher.

 

[Stroganoff]

http://www.bogleheads.org/wiki/Bond_basics

Bogleheads Wiki -- great knowledge to devour.

 

[krl7044]

That does help, thank you. I think where I was confused is that I was assuming that once you buy a bond, you hold it until maturity. If you do that, then what other people are doing is kind of moot because you already paid whatever the price was to buy the bond. So if the interest rate goes down and you keep the bond, you still paid the lower price for your bond. But I guess the point is that most people in that situation would try to sell the bond because now its price is higher.

Surprising number of people trade bonds. I would never recommend doing that unless you are a pro. If you hold a long term bond to maturity and the interest rates rise quickly, yes, you would be out of luck. That's why in this environment I like barbell portfolio. If you have a short maturity bond and a longer maturity bond (say a 5 year and a 10 year one), if at some point interest rates rise, the shorter bond matures quickly so you can reinvest the money at a higher interest, while the longer maturity bond now becomes your shorter maturity bond. You can also reinvest all of the interest coming from longer maturity bonds into bonds with higher maturity, since you typically get semi-annual interest payments from bonds (such as municipal bonds). Selecting maturities in a barbell fashion (say, 50% in short and 50% in intermediate) allows you to have a defensive portfolio that can generate a higher yield than a money market or a CD, and also be defensive when it comes to spiking interest rates. That's why in this environment I try to keep maturity of the intermediate bonds under ~15 years or so (for munis). Basically, the yield curve will tell you the sweet spot for selecting the right yield vs. maturity (and it is always different, so there is no rule of thumb). Right now it seems that for munis, 8-year bonds and 15-year ones have the highest yields, but at any one time you don't have the choice to buy the perfect bond, so I typically forage around for the best choices available throughout the year (thus one ends up with a whole spectrum of maturities, like two overlapping curves, with spikes around 8 years and 15 years).

While this might sound a bit complex, using individual bonds is much better than buying muni bond funds, which not only charge an asset-based fee (0.2% starts adding up once you have $1M or so invested), but which use much lower quality bonds. If you invest in a handful of high quality bonds, no diversification beyond that is necessary (once you hit maybe $500k, looking to diversify across other states can make sense). I also like muni bonds for such things as higher education planning because you know exactly how much money you'll get when you need it.

 

[krl7044]

http://www.bogleheads.org/wiki/Bond_basics

Bogleheads Wiki -- great knowledge to devour.

This is great information. Unfortunately, there isn't a guide online on how to actually buy bonds on the open market (including how to pick and compare various types of bonds). Took me a couple of years to figure out what's going on, and I only buy certain types of bonds (select munis and in the past - Treasuries). Without professional advice, I'd stick to bond funds since there are just too many pitfalls and mistakes that can be very costly to novice investors. While Treasuries are rather easy to buy because they are liquid, munis are probably the most complex bonds to buy, and I avoid corporate bonds. I know some people like TIPs, but I'm not one of them. While I would use TIPs bond funds/ETFs, I'd leave the actual management to fund managers who have time (because TIPs are a tiny part of one's portfolio). Munis are another thing altogether given the tax brackets of doctors and dentists, and given the current dislocation/spread between munis and Treasuries. I recommend having a lot of after-tax assets in munis for various reasons, so that's where it makes sense to buy individual bonds.

 

[QofQuimica]

Thanks for all your help, Konstantin.

 

[krl7044]

Thanks for all your help, Konstantin.

Always glad to share my knowledge and experience. I was a DIY before I decided to make a career out of it. Keep at it - you'll be much better educated about every aspect of your finances, and even if you do hire some professional help, at the very least you'll be able to evaluate their performance (and remember to set that bar high!). Most professionals in the advisory field are unfortunately nowhere near as educated about finances as most dentists/doctors I work with, probably because doctors/dentists actually take the time to continuously learn new things. I learn new things every day, and questions from forums like this provide a great educational opportunity for me as well. Please keep the questions coming!

 

[Mapplicant]

Question: my thinking process in mitigating interest rate risk and price risk is to hold a ladder of several bonds (US treasuries only) with average duration not to exceed 5 (or maybe as long as 7?) years.

By limiting to individual US treasuries only, I can cut out any expense fees in a bond fund (even low ones like Vanguard) and eliminate credit risk and buy holding ladder (or barbell I've read too but owning 30-year bonds seems to have too much interest rate risk) will also mitigate interest rate and price risk as well.

And by going through TreasuryDirect I can bypass what seems to me is a very complicated secondary bond market. I am also buying at par and holding each bond to maturity and reinvest to keep ladder about same duration. So even in the interim if rates go up or down, my "theoretical" value of bonds will go up or down but since I am holding to maturity that doesn't matter if I simply hold until maturity and then reinvest as each rung of the ladder matures.

I am already taking risk on the equity side (currently in Vanguard's total stock market index) so I was thinking why buy equity-behaving-like bonds such as corporates or those with long durations?

I am still learning abut bonds and it is quite complicated subject, much more so than investing in equities, imo.

 

[krl7044]

Question: my thinking process in mitigating interest rate risk and price risk is to hold a ladder of several bonds (US treasuries only) with average duration not to exceed 5 (or maybe as long as 7?) years.

By limiting to individual US treasuries only, I can cut out any expense fees in a bond fund (even low ones like Vanguard) and eliminate credit risk and buy holding ladder (or barbell I've read too but owning 30-year bonds seems to have too much interest rate risk) will also mitigate interest rate and price risk as well.

And by going through TreasuryDirect I can bypass what seems to me is a very complicated secondary bond market. I am also buying at par and holding each bond to maturity and reinvest to keep ladder about same duration. So even in the interim if rates go up or down, my "theoretical" value of bonds will go up or down but since I am holding to maturity that doesn't matter if I simply hold until maturity and then reinvest as each rung of the ladder matures.

I am already taking risk on the equity side (currently in Vanguard's total stock market index) so I was thinking why buy equity-behaving-like bonds such as corporates or those with long durations?

I am still learning abut bonds and it is quite complicated subject, much more so than investing in equities, imo.

Here are some issues to consider:
1) On a tax-adjusted basis, are treasuries yielding more than municipal bonds? This is an individual question, and for some it might make more sense to invest in Treasuries. You probably are investing indirectly through CDs and directly through balanced portfolio inside your retirement plan. A 10-year treasury bond yields 2.5%. A 10-year municipal bond yields around 2.3%. If you are in a 40% tax bracket, this is equivalent to 3.8% from a taxable bond (which treasuries are, unless you buy them in an IRA). I don't like holding individual bonds in IRAs though. I like the IRAs to have the potential for growth.

2) Yes, you are right, if you have a ladder with 5-year bonds, you'll reinvest at a higher rate quickly. But if the interest rate remains low for decades (Japan?), then you will be stuck with a glorified money market. Ladders work when interest rate is high, and don't work at all when they are low. With 5-year maturities you'll get a whole lot of zeros for treasury interest rates. At 1.66% (5-year rate), you are better off with a 5-year CD, and there is no need for a ladder (right now, CDs and money markets yield more than treasuries). So basically, what you want is the highest rate at the lowest maturity, and you can get that with a 5-year CD (2%), so you put everything into a 5-year CDs, since you can redeem them quickly without having a ladder.

3) I would never recommend 30-year bonds. Right now, barbell works well with intermediate-term bonds. The idea is that because of the interest rate dislocation, short term bonds are represented by money markets and CDs. So what needs to be 'filled in' are intermediate bonds (7-15 year maturities). Again, 7-15 year treasuries don't provide enough yield vs. munis on a tax adjusted basis. You are right, holding to maturity is key, and given that the economy is not doing so well, I'm not optimistic that we'll have higher interest rates even 7 years from now. But this is why we can design a longer-term portfolio that pays good interest that can be reinvested in higher interest-rate bonds.

4) Planning aspect. I like municipal bonds in after-tax account for the ability to use them for higher education and/or income planning. I work with dentists, and many accumulate large assets inside retirement plans. Many will be hit with high RMD distributions. Having a large after-tax portfolio of municipal bonds will allow them to have a tax-free income stream, and given that in retirement they can still end up in high tax brackets, this can be a big plus.

I have nothing against Treasuries. It is just that currently, there is a large gap between treasury/municipal bond yields, so I'm not considering using individual Treasuries with my clients. When it comes to retirement plans, that's completely the opposite - I prefer using Treasury bonds/notes as a diversifier/safe asset, and I end up using quite a bit of them to balance out the aggressive index fund allocation which contains a lot of small cap/foreign exposure.

I stay away from corporates because of high risk, and a lot of due diligence. Also, with munis/treasuries, you can buy a handful of bonds and be diversified. Not so with corporates, which sometimes behave like stocks.