Why are rising interest rates bad for bonds?

You are partly on to the answer in the question itself. When interest rates go up the value of existing bonds go down. There are two main things to be concerned about with bonds what is the interest it pays and what is the value of the bond itself. Let’s say hypothetically that you purchased a bond for 1,000 and the interest on that bond was 6%. If interest rates go up to say 8% then your bond is no longer worth the 1,000 you paid for it because someone could purchase a new bond and get a better rate. You also asked if rates go up don’t you get a higher rate….well using my example, if you buy a bond at 6% your interest is 6% period. It does not change like it would in a savings account for example. This is a risk with bonds that some people don’t consider. It is appropriatley called “interest rate risk”. Hopefully I explained that ok.

consider this: bonds carry a principal amount that is due at maturity, usually $1,000.

The bonds go out to auction. The auction is, how much will you pay me to get $1,000 in one year? (or 5 or 10 or 30)? Let’s say you’ll pay $950, that means the bond will appreciate by $50 over a year for a simple interest rate of 5.26%.

If something happens tomorrow, and interest rates go up to 10%, the value tomorrow for your bond will drop from $950 (what you paid) to about $910. You can either sell the bond for $910, or hold it to maturity and get the $1,000.

Principal = Investment*rate . With Principal fixed, the rate and the investment have an inverse relationship. The higher the rate, the lower the amount needed to invest.

While you haven’t lost money if you hold it to maturity, you are missing the opportunity to get a 10% return. That’s why a short term bond (or CD) pays a lower rate than a long term bond.

It’s like holding a hot potato. When you buy a bond for $1 you buy a peice of paper that you can turn back in for $1.03 (3% interest) in one year (term). If interest rates go up (say to 5%) they start selling bonds for $1 that will be worth $1.05 in one year. BUT, your dollar is wraped up in that first bond. If you hold that bond a year your going to make your 3%. Suppose you really have to sell that bond. Who is going to buy a bond for $1 that will make 3% when they can buy a bond for a $1 that will make them 5%, Your good friend says, tell you what since you need the money I’ll give you $0.98 for that bond.

You cave because you really need the money. After you collect your $0.98, you ask your friend how he came up with that price? He says that if he buys it for $0.98 and redeems it in a year for $1.03 he makes $0.05 or 5% interest because after all thats the going rate.

Suppose you buy a bond at 3% and the interest goes up to 5%. Since the amount that the bond pays is fixed, the only way that you can provide someone with 5% interest is to sell the bond for less than you paid for it.

Rising interest rates in bonds are fine if you don’t own them. If you buy the bond when the interest rate is high, you will earn more money. But as @LostInParadise said, if you buy a bond for, say $20 at 3% and the interest rates on new bonds go up to 5%, then you’ll have a harder time selling your bond if you want to sell it and you will get less money. If you hang on to the bond, however, you will still continue to earn your 3% until it matures.

Bond mutual funds are a little different, though, in that bond mutual funds buy up new bonds all the time. The share prices still fluctuate, though, based upon the interest rate.

@Rarebear Could you continue that story, please? How do bond fund prices fluctuate in response to interest rates and why?

@wundayatta – It’s kind of related to the discounted value of money in relation to time. If you buy a bond at a lower interest rate than those currently being sold, it will be worth less when it matures than those being sold now. But, it will also mature sooner. So, the initial price/investment in the bond doesn’t change except for natural inflation/deflation and other effects on the value of the dollar…but if you’re trying to sell your bond it may be that you have to discount the price of it based on what it’s worth to make it more attractive than investing in a bond that will return a higher interest rate, and eventually be worth more.

@iamthemob I’m not talking about bonds. I’m talking about bond funds.

@wundayatta – Sorry about that – but the answer is still the same. It’s simply that instead of value of an individual bond, you’re talking about the value of a share…and fluctuations have a less significant impact on the value. Also…they are more liquied (there’s more of a market for the shares).

A share in a bond fund is sort of like letting the fund diversify your risk in individual bonds for you. As the fund purchases and sells individual bonds, it reduces the overall effect of interest rate fluctuations as it will sell some owned at a lower rate, by some at a higher rate, etc. The owner of the share gets dividend payments which are essentially the average interest in the diversified portfolio of the fund.

It’s like if you own three bonds bought at 3%, 4% and 5%. All were purchased at $20.00. But the 3% can only be sold at $16.00 because of the lower rate, 4% at $18.00 and the 5% at the full $20.00. Selling all three would result in an average price of $18.00 for all, which is less of a loss than a sale if all three were owned at 3%.

A bond fund price for a share might be the equivalent of owning three of the bonds in the portfolio (a percentage of the underlying assets) and therefore a share like the above would also be, for arguments sake, $18.00. It might be slightly higher, as there’s a better market for it (and resaleability is part of the value).

Closer?

@iamthemob Thanks. But how do they make their money? Is it in buying and selling bonds, or is it in holding them until payout? Is it about making bets on which way interest rates are going to go? Have bond funds been doing badly because interest rates have been so low, or does that not really affect bond sales?

@wundayatta

I’m sure that both the buying and selling of bonds. But as they also sell shares in the fund, that’s raising capital as well.

Bonds are very, very safe investments. So, it’s less about speculation, I’m sure, and more about administration. They’re going to be attractive as a way to diversify other stock portfolios, so there’s a built-in market.

And the interest rates are only going to impact bond funds that don’t respond well to shifts in them. Because they’re safe investments, I would wager that bond funds might actually be doing quite nicely in this market – that’s just a guess though.

The negative impact of one risk aspect doesn’t determine the performance of the bond. I know that’s not what you’re saying, but until we know about how a particular fund reacts, we can’t really say what the interest shift does to the fund.

@wundayatta and @iamthemob
Just getting back to this now. @iamthemob answered the question of the fluctuation bond fund price pretty well, so I won’t repeat it.

To answer the question of how the company makes money, it’s fees. When you look at buying a mutual fund, you should look at the prospectus and see how much the fee is. My Vanguard bond fund, for instance, has a fee of 0.2%, which is reasonable.

If you’re asking the question about how you make money, it’s by dividends. Each bond fund has a payout each year, depending on the bond fund. The longer term the bonds that the bond fund holds, the higher the dividend payout. So why not just go to a long term bond fund all the time? Well the long term bond funds, since they’re holding investments for a long period of time, is more apt to have share price fluctuations than a short term bond fund.

Take one extreme—a money market fund. Money market funds are basically extremely short term bond funds (I think the holdings are for about 30 days) where they try to hold their share price absolutely stable, without fluctuation whatsoever. As a result, though, the dividend you get from them is low (and in this economy, basically nonexistant). When bond prices go up, though, dividends will go up, but the share price stays the same.

The other extreme example is a long term bond fund. In a long term bond fund, your dividend payout is much higher than in a money market account, but because they are holding bonds for several years, the share price can fluctuate pretty widely. You still get the dividend, but if you sell the bond you could lose money if you sell it at a loss. But you’ll only lose that money if you sell.