One of the asset classes that can be productively used by many investors is fixed-income investments – bonds. We have written about them before in a few different contexts. However, I have been asked several times recently about the wisdom of investing in bonds in an environment of rising interest rates. That’s what I’ll address here.
The reason that the question comes up is that when interest rates go up, the value of all existing fixed-rate bonds goes down. If we expect that interest rates will go up, as most people do, then are we not saying that the value of any bonds that we invest in will go down? Could we have a net loss on the bond investments? If so, should we avoid bonds until we think that rates have peaked out? Or is there something else that can be done?
First, let’s briefly review the relationship between interest rates and bond prices. The rate of interest that a bond issuer originally set on the bonds was the lowest amount that they could pay at the time, given the general price level of money – i.e. the prevailing interest rates. The bond issuer had no control over this. They had to pay the prevailing rate, or not borrow the money.
Using Bonds to Invest in a Rising Interest Rate Environment
For example, if a company that was issuing the bonds had credit rated AA and was issuing bonds that matured in ten years, then there was a going rate for ten-year AA bonds. Say it was 6%. The issuer puts a coupon rate of 6% on the bonds. Since bonds normally have a denomination of $1000 each, the 6% coupon rate means that they will pay $60 each year, every year for the next ten years, in interest. At the end of that time, the issuer repays the $1,000 face amount of each bond.
Now suppose that it is two years later. The original bonds now have eight years to go. Suppose that the interest rate environment has changed. AA-rated companies issuing comparable bonds (with an 8-year maturity) are now paying 8% per year, or $80 per bond.
An investor who owns the original bonds is still receiving his $60 per year, and would continue to do so for the next eight years. This is a disadvantage of $20 per year compared to comparable newly-issued 8-year bonds. If the investor now wishes to sell that original 6% bond, he will be able to do so only if he is willing to sell at a discounted price since these bonds are no longer competitive. The new buyer would need to be compensated for the $160 reduction in interest (8 years X $20 per year) that he would give up compared to just buying a new 8-year bond. In fact, the discount that would entice him to buy the old bond is not quite $160. It is the present value calculated at 8% (the current prevailing rate), of eight annual payments of $20. This present value is about $115. So, the value of the original bond would now be $1000 – $115, or $885. That’s what the original buyer of the bond could sell it for today.
Note that if the original bond buyer were to sell the old bond now (at its current value of $885) and replace it with a new 8% 8-year bond, his situation would not actually change at all. He would lock in an extra $20 a year for eight years. We know that the present value of this income stream would be $115. But he would have to take a $115 loss on the original bond right now to get there, cancelling out this increased income.
Another way to say the same thing is that the rise in interest rates has damaged the original bond investor by $115, no matter what he does now.
If instead of going up, prevailing interest rates were to go down, then the value of all existing fixed-rate bonds would go up, by the same logic.
To return to the original questions, should we buy bonds now, when we expect interest rates to rise?
The answer is – it depends, and we may want to modify our buying somewhat.
In the first place, no one can be sure that in fact rates will rise or by how much. Interest rate increases have been forecast every year since 2010. Short-term rates did not even begin to rise above zero from 2009 through late 2015, and have barely moved since then.
Secondly, part of the point of allocating some money to bonds is to shield that money from the stock market (and other volatile markets like gold or real estate). Bonds can change in price as noted above, but nothing like what can happen in the stock market. In 2000 and again in 2008, the major stock market indexes dropped by around 50%. What would it take for the value of a bond to drop by 50%?
As of this writing typical yields of high-grade corporate bonds with maturities of 10 years, 5 years and 2 years are about 3.6%, 2.4% and 1.8%, respectively.
For these bonds to lose half their value, 10-year rates would have to rise from 3.6% to over 12%. Five-year rates would have to go from 2.4% to over 22%. Or 2-year rates would have to rise from 1.8% to over 45%.
None of those things is very likely to happen. And the chance of major damage is clearly much less the shorter the term of the bonds is.
So, if the point of owning bonds is to generate some return while protecting that money from bad markets in other areas, it could still make sense. In that case, the best strategy would be to keep maturities of any newly purchased bonds short in order to minimize the impact of rate increases. As rates do rise, if they do, then our returns will rise with them as we reinvest in higher rate bonds in the future.
This is the bare bones of a strategy called a modified bond ladder. We discuss this, and much more, in our ProActive Investor class. If you’d like to know more, please contact your local center.