Bonds are valued for their relative safety compared to stocks. However, bond prices are subject to changes in interest rates. A fundamental concept in bond investing is the inverse relationship between bond values and interest rates. But why do bond values decrease when interest rates increase?
Let's delve into this by considering a practical example, which can be explored using our bond value calculator.
Imagine purchasing a 5-year bond for $1000 that pays an annual interest of 5%. If interest rates rise to 6% just after your purchase, the value of your bond will decrease. This is because new bonds will offer higher returns, making your lower-interest bond less attractive. The exact decrease in value can be calculated in our calculator here.
Assume you buy a 5-year bond, and immediately, interest rates increase from 5% to 6%. If you enter this into the bond value calculator, you'll get a value decrease of 4.21%. Let's calculate this. Suppose you buy the bond for $1000. It pays 5% interest, meaning you will receive $50 per year. Also, it matures in 5 years, meaning you will receive $1000 in 5 years. So, the payments are:
| Year: | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|
| Payment | 50 | 50 | 50 | 50 | 1050 |
Let's take the $50 payment in one year. To calcualte its value today at a 5% interest rate, we divide it by 1.05 to get a "present value" of $47.62. That is, you'd need to invest $47.52 at a 5% interest rate to receive $50 in one year, so at a 5% discount rate, $50 in one year is worth $47.62 today. For year 2, we'd need to divide 50 by 1.05^2 to get $45.35. Looking at all 5 years:
| Year: | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|
| Payment | 50 | 50 | 50 | 50 | 1050 |
| Present Value | 47.62 | 45.35 | 43.19 | 41.14 | 822.70 |
If you add up the present values, you get a total of $1000, the price we paid for the bond. Now, suppose interest rates increase to 6%. An investor could then buy a $1000 bond and get $60 per year in interest, instead of $50. So our original bond is worth less than that. We need to recalculate the Present Values by dividing the payments by 1.06 per year, instead of 1.05. We get:
| Year: | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|
| Payment | 50 | 50 | 50 | 50 | 1050 |
| Present Value | 47.17 | 44.50 | 41.98 | 39.60 | 784.62 |
The adjusted total present value is now $957.88, reflecting a decrease in the bond's value by $42.12, or approximately 4.21%, matching with our calculator's estimate.
The bond's value is now $957.88. If we subtract this from $1000, we lost $42.12, or approximately 4.21%. This matches our calculator's estimate.
Conclusion
This example illustrates the fundamental principle that bond prices and market interest rates move in opposite directions. This inverse relationship is a critical aspect of bond investing, emphasizing the importance of interest rate risk. A simple approximatation is that if a bond matures in X years, an interest rates increase by I%, the bond will drop by approximately X*I%.
Note that the longer you need to wait until maturity, the greater the interest rate risk. To avoid this, you can buy bonds that reach maturity when you need the money. If you need money in 3 years, you can buy a 3-year bond. Then, you will be paid the original interest rate regardless of interest-rate changes in the meantime.
Also note that there are additional risks.
Default Risk: if the issuer goes bankrupt, holders will likely lose money. You can avoid this by buying government, rather than corporate bonds.
Inflation Risk: Inflation will reduce the return you receive in future dollars. You can avoid this by purchasing inflation-protected bonds. U.S. inflation-protected bonds are known as Treasury Inflation Protected Securities (TIPS).