There are many different economic factors that can change interest rates. The Federal Reserve can act to change interest rates. Interest rates can be lowered to increase borrowing and spending during a slumping economy. Interest rates are also used to manage inflation.
No matter what causes the change in interest rates, the change has a direct impact on how bonds are priced. When interest rates increase, the value of existing bonds decreases. The opposite occurs when interest rates are reduced. When that happens, the value of an existing bond would increase in value.
Not all bonds are the same. Bonds have different maturity dates. There are different issuers such as the Treasury, corporations, and municipalities. Different bonds have different coupon rates.
With bonds, the value of a dollar today is worth more than a dollar tomorrow. Today’s price of a bond is based on the total of future cash flows. The value is discounted because they are not available today. When there are changes in interest rates, all bonds are impacted. Not all bonds, however, are impacted equally.
The price of a short-term bond is affected less by the increase in interest rates than a longer-term bond. Long-term bonds maturity value and interest are paid with future cash flows. They are paid in the distant future. When there is an increase in interest rates, the long-term bonds become discounted and decrease dramatically in value.
The interest rates are also known as the coupon rate that is periodically paid also impact the bond price volatility. The higher the coupon rate, the more cash that is paid in interest to the investor prior to the maturity date. When interest rates increase, the future cash flows are discounted at a higher rate. The lower coupon bond will have more cash flow in the future. The maturity value of the bond represents a larger portion of the total cash flow. The current value of the bond will fall.
To determine the risk of a bond, an investor needs to look at maturity and coupon rates. The most volatile bonds have lower coupons and longer maturities. Less risky bonds are shorter until they reach maturity and have a high coupon rate.
Most individual investors use bonds to reduce the volatility of their overall portfolio and for income. If you are using the bond portion of your asset allocation to reduce the overall volatility of your portfolio, consider bonds that have maturities that are shorter than five years. Also, avoid zero-coupon bonds.
How much do bond prices change? The prices of bonds do change, but not as drastically as with stocks. What you can lose in bonds in one year, you can lose in stocks in one day. Even though bonds are less volatile than stocks, it is still important to understand how interest rates affect them.
For example, assume that you have a bond with a 30-year maturity and a 6% coupon rate. How much would the value of the bond change if there was a 2% drop in percentage points from 6% to 4%? The bond would increase in value by almost 35%. A bond that had a face value of $500 prior to the interest rate decrease would climb to $674.
What about if there was an increase in the interest rate from 6% to 8%. The bond would decrease in value by almost 23%. That $500 bond would have a loss of $113 in value.
The only way to reduce the price volatility of the bond portion of a portfolio is to consider shorter maturities. When looking at mutual funds that invest in thousands of different bonds, look at the average maturity and the average coupon rate. That will give you a ballpark of what the price volatility of the overall portfolio would be. Below are a few examples of Vanguard Bond Funds:
Vanguard Total Bond Market Fund (VBMFX)
Average Maturity: 8.4 years
Average Coupon: 3%
Vanguard Long-Term Bond Index Fund (VBLTX)
Average Maturity: 24 years
Average Coupon: 4.4%
Vanguard Short-Term Bond Index Fund (VBIRX)
Average Maturity: 2.9 years
Average Coupon: 2%
Mutual fund managers keep a keen eye on interest rates and other economic factors. They can adjust their portfolio by buying or selling bonds with shorten or longer maturities based on projected interest rate changes. Fund managers are limited as to what they can buy and sell based on the fund’s investment objective statement found in the prospectus. For example, a short-term fund cannot increase its holding in long-term bonds just because interest rates might be falling.
There is also a quality factor to consider. When interest rates are increasing, lower-rated bonds tend to fall in price faster than high-quality bonds. Bonds with a higher default risk fall the fastest.
If the economy was in a recession, a rise in interest rates would drop the price of a high-yield (junk) bond with a low rating. A double or triple-A rated corporate bond with the same maturity would also fall in price, but not as quickly as the lower quality bond. U.S. Government bonds have historically been rated as the highest quality bonds.
It is just as difficult to try to time changes in interest rates as it is to time the stock market. There has been speculation of raising interest rates for many years and they are just starting to occur. Economics and fund managers can make predictions as to where interest rates are heading, but nobody truly knows for sure.
When you are building the bond portion of your asset allocation, keep in mind why you are buying bonds. Be aware how interest rates affect how bonds perform. If you want to be more conservative, focus on high-quality government, corporate, and municipal bonds. A risk-averse investor should also stick with short-term bonds or bond funds.
If you want to take on more risk, do so in the stock portion of your asset allocation. That is not what bonds are intended for in an individual investor’s portfolio. Bonds should be used to reduce risk and provide income, not add to the overall risk of a portfolio.
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