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How Interest Rate Changes Affect Bond Prices
Category: Finance
Article added by: Cathy Pareto


How safe is your bond portfolio in an increasing interest rate environment? Surging prices in
the housing and commodity (specifically oil) sectors have triggered inflation fears that have
prompted the Federal Reserve to increase the federal funds rate seven times since June of
2003, the most recent hike occurring last week. The fed-funds rate is the rate that banks
charge each other for overnight loans. As the fed funds rate increases, interest on short term securities also goes up. Those rate hikes, despite inspiring higher bond yields for investors, can have a negative impact on the price of your bonds. This article will reflect on why this happens and what you should do to protect yourself.

Bond Risk

Investing in bonds is not a risk-less exercise. Many investors are mistakenly under the
impression that bonds do not lose value. In fact they do.

Bonds are subject to a number of risks, including:

• Default risk: risk of bond issuer defaulting on debt (also known as credit risk)
• Reinvestment rate risk: risk from the falling interest rates will cause cash from investment to fall
• Purchasing Power risk: risk that inflation will lower value of bond interest payments or
principal payment, forcing prices to fall
• Interest rate risk: risk that a change in interest rates will cause market value of bond to fall

Interest rate risk as it relates to bond duration is important to understand.

Understanding Duration and Interest Rates

Duration is defined as the weighted measure of time it will take for a bondholder to receive the interest and principal of a bond. Duration, of course, does consider the coupon payments. So, for two bonds with the same maturity, the bond with the higher coupon rate is said to have the lower duration. A bond’s duration is of critical importance for investors. When interest rates rise, the price of an outstanding bond will fall to bring the yield of the older bond into line with the higher interest new issues. Conversely, when interest rates fall, the price of an outstanding bond will rise, until the yield of the older bond is low enough to match the lower interest rate on new issues. Let’s say for example, Jane owns a 30 Year Bond with a par value of $10,000. At the time of purchase five years ago, the bond had a 4% yield. Let’s also assume that new bond issues now offer a yield of 6%. Jane no longer wants to keep her lower yielding bond, opting instead for the bond with the 6% yield. The only way that Jane will be able to unload her bond (whose yield is below current market yields) will be to sell it at a discount (or below par). Her bond is worth less than its face value, because interest rates went up.

Therefore, in a rising interest rate environment, as we are now experiencing, investors should consider lower duration (maturities with 5 years or less) bonds because as interest rates increase, the value of their bond will depreciate. While, investors holding bonds with longer durations will likely experience a capital depreciation of their bond.

Duration and Volatility

From the time a bond is issued, bond prices and yields will fluctuate according to market
conditions. Any change in the level of interest rates will have an immediate and predictable
effect on the price of bonds.

There is a direct link between a bond’s maturity and its yield. Long term bonds have historically provided higher average returns than short term bonds. That’s no secret. However, since long term bonds are much more sensitive to interest rate fluctuations, they are also more volatile as measured by standard deviation.

One of the best observations we can make from this chart is the vast difference in standard
deviation between the 5 year note and 30 year bond. Long term bonds are substantially more risky than short duration bonds for not much more benefit. The return for the long term bonds is a paltry .03% higher, while the standard deviation is a whopping 5.02% higher. There is simply not much benefit to owning a long bond position. Why? Investors are exposed to far greater risks (recap: reinvestment, interest, purchasing power, and default risk) the longer you hold a bond.

Conclusion

Persistent and rapid economic growth can lead to inflation, thereby provoking the Fed to tighten monetary policy by increasing rates. This, of course, would erode a bond’s value. We are experiencing this right now. As an investor, you need to understand how bond prices are
influenced by such economic cycles. One of the best ways to guard against interest (and the
other) risks it to control the duration of your bonds. Regardless of the direction of interest
rates, investors should really consider bond portfolios with durations of less than five years.
So, if you’re long right now in the current rate environment, I suggest you go short….and stay there.


Posted By: Cathy Pareto
Web: http://www.cathypareto.com
Contact: e-mail


About the Author:
Cathy Pareto, MBA, CFP®, AIF® is the Founder and President of Cathy Pareto & Associates, Inc. For over twelve years, Cathy has been helping financial consumers and professionals understand the world of investments and finance with a sound, but down to earth money management approach. Money management does not have to be an intimidating and mystifying process. Cathy's belief is that there is more to investment management and financial planning than just the numbers. It takes commitment, clear communication and trust between the Advisor and the Client to plan out a strategy, and it requires the experience of a competent Advisor to execute that strategy. For over a decade Cathy was a Senior Financial Advisor for another Miami based investment advisory firm, where she managed over $200 million in assets for high net worth clients and retirement plans. She has extensive experience in retirement issues, asset allocation, investment selection, investment management, education planning, estate planning coordination, and asset protection strategies. Additionally, she was an Adjunct Professor and Faculty Coordinator for the CFP® Program at Florida International University’s College of Business. Educational Background Cathy earned her BA in Finance and later her Executive MBA at Florida International University, graduating in the top 20% of her class and as a result she was inducted into the prestigious Beta Gamma Sigma Graduate Business Honors Society. In the Media Cathy Pareto’s articles have been published in periodicals and websites, including Women in Business,Investopedia.com, Miami Medicine, Florida Medical Business, AccountantsWorld.com, My Financial Advisor, Indexfunds.com, and Fundsinteracctive.com. Her media contributions include quotes in BusinessWeek, The Wall Street Journal, The Sun Sentinel, CNNfn, Latina Magazine, Hispanic Trends, AARP's Segunda Edad, and many other financial publications. She has appeared on television and radio shows including CNBC’s “Power Lunch”, WLRN/NPR’s “Topical Currents", “Wealth & Wisdom”, Total Picture Radio, Landed Radio and more. www.cathpareto.com Professional Memberships Greater Miami Estate Planning Council - Current Member of the Board of Directors United Way of Miami Dade Young Leaders - Current Member NAPFA National Association of Personal Financial Advisors - Current South East Region Board Member Florida International University Executive MBA - Current Member of Professional Advisory Board Financial Planning Association - Current Member