Bond Prices

Bond Prices

Dear Garden State Trust:

I’ve read that when interest rates go up, bond prices go down. Why should this be so? It seems a bit irrational to me.

—Cynical Investor

Dear Cynical:

It’s not irrational. It’s not emotional at all; it’s just math.

Here’s a simplified example. You have a bond with a face value of $1,000 that pays 5% every year, or $50.  When the bond matures you receive $1,000.

Now imagine that interest rates have jumped to 7%, so a new $1,000 bond pays $70 every year.  What happens to the value of your 5% bond?

If you hold the bond to maturity, nothing happens, you still get that $50 every year and $1,000 at maturity.  But if you want to sell your bond early, no one will pay $1,000 because they will want to collect 7% per year, the same as from a new bond. They will pay only $714 for your bond, because 7% of that amount comes to the $50 your bond pays.

Changes in interest rates are only one part of the story.  The amount of decline in a bond’s value also depends on its maturity.  Shorter-term bonds do not decline nearly so much in value, because the principal will be repaid sooner. Longer-term bonds are more vulnerable to interest rate changes.

This is why bond investors tend to keep a sharp eye on inflation and inflationary expectations.

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(July 2021)
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