Home » Articles » Bond Prices And Interest Rates – The Inverse Relationship

Bond Prices And Interest Rates – The Inverse Relationship

Last Updated:  July 26, 2011

Most investors don’t realize the inverse relationship which exists between bond prices, and interest rates. This can be a dangerous misunderstanding, as “safe” bond investments can really hurt you financially.

With individual bonds (and especially bond funds with no finite maturity date), as interest rates rise, the values of currently held bonds drops. Believe it or not, it’s possible to lose as much money investing in bonds as you can investing in the stock market.

Bond prices and interest rates are inverse.
The relationship between bond prices and interest rates is inverse. When one rises, the other drops, and vice versa.

Of course, the values on individual bonds only affect you if you sell prior to maturity. If you buy and hold a bond until it’s redeemed, it doesn’t matter much what rates do in the interim (other than the opportunity cost or loss of “what could have been”).

To understand why interest rate changes affect your bond holdings let’s look at a quick example. Assume you buy a ten year bond for $1,000 when interest rates are yielding 7%. The principle you receive at maturity is $1,000, and you receive two coupon payments each year totaling $70 for a total interest payment of $700 (10 years time $70 each year).

Now let’s say in 3 years, new interest rates are at 9% because the economy has been heating up and the fed wants to slow things down (this would be nice!). Your bond is worth LESS now. Why? because why would anyone want to by your 7% coupon bond when they could get 9% on a NEW BOND?

You wouldn’t expect to sell your 3 year old car for the same price as a new one would you?

Now assume that in two more years (5 years into your 10 year bond), rates drop to 5%. Here’s where your 5 year old car actually becomes a classic! You wouldn’t DREAM of selling your 7% bond to someone for $1,000 knowing that the open market is only paying 5% right!

That’s how it works. As rates rise, bond values drop. As rates drop, bond values rise.

 

What this inverse relationship means to you now!

Where this may get dangerous, is in times like the current economy. Investors are buying “safe” investments in large chunks, for long periods of time. Those who are buying longer term bonds are taking far more principal risk than they probably realize. Because of this, they’re subjecting themselves to potential financial ruin as rates rise and their bond values drop.

Buying 10 or 20 or 30 year bonds today to chase yield is one of the single most foolish things an investor could be doing right now. Close to as foolish as piling onto the gold bubble! A bubble which may have farther to go, but make no mistake – when my kids 23 year old snowboard instructor asked me about investing in gold it’s clear, the last of the herd is piling on!

All of that being said, predicting interest rates is a dangerous game as well. In mid 2009, when EVERYONE thought rates had hit rock bottom, 43 of the worlds top 50 economists predicted higher rates with great certainty in the near future. We haven’t seen them yet…

A calm cool and collected approach to diversification (which INCLUDES fixed income in reasonable amounts) is the only prudent way to approach a long term retirement period.


Leave A Reply

Your email address will not be published.

{"email":"Email address invalid","url":"Website address invalid","required":"Required field missing"}

Other Articles You Might Like: