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.
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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