One of the most common questions we get from clients who hold bonds in their portfolio is “Why do bond prices go down when interest rates go up?” Bonds are admittedly confusing, but they add a damping effect to portfolio volatility and a nice income stream, so their somewhat confusing nature should not warrant their dismissal from a portfolio. In this article, we’ll attempt to explain why bond prices and interest rates move inversely to one another.
Tale of two bonds
Let’s take a look at a hypothetical new bond issue of 10-year corporate bonds, say from McDonald’s. The bonds may come with a 4% coupon and have a due date in 10 years. The bonds come priced at 100 cents on the dollar, or “par”. Being corporate bonds, these may pay their interest semiannually in June and December. The buyer of these bonds knows that for every $10,000 of bonds she owns, she will get $400 a year in interest and those interest payments will be made once in June for $200 and once in December for $200.
Now let’s move ahead a week or so. Let’s assume that interest rates have risen and McDonald’s comes out with another new issue of 10-year corporate bonds. These new bonds come with a 5% coupon and have a due date in 10 years. These bonds come priced at 100 cents on the dollar, or “par”. The buyer of these bonds knows that for every $10,000 of bonds she owns, she will get $500 a year in interest and those interest payments will be made in June for $250 and December for $250.
Which bond seems better?
Which bond would you rather have? Both are from McDonald’s, both are due in 10 years, both pay some interest every six months. You would, of course, want the bonds that pay $500 per year rather than the bonds that pay $400 per year. What can be interpreted by your decision? Well, we can assume that what you are saying is “The bonds that pay $500 per year are worth more to me than the bonds that pay $400 per year.” If you are able to buy the bonds that pay $500 per year at 100 cents on the dollar, then by definition you are saying that the bonds that pay only $400 a year in interest are worth slightly less than 100 cents on the dollar. Without getting too technical, what you have just discovered is that a bond’s price has gone down when interest rates went up. The bonds that pay $400 per year are worth less than they were a week or so ago.
Is the first bond worth $0? Well, no, of course not. It is paying $400 a year in interest and it comes due worth $10,000. It is absolutely worth something. Is the first bond (which pays $400 per year in interest) worth 100 cents on the dollar? Well, no, because you can buy the second bond that is paying $500 per year in interest at 100 cents on the dollar. So, it can be safely assumed that the first bond is worth between $0 and 100 cents on the dollar.
If you want to learn more about how bonds work and what they are, check out this beginner level article: what is a bond?
Questions? Comments? Reach out to us. We have extensive knowledge and experience with bonds and would welcome your thoughts.