There’s no shortage of fear mongering in the financial media these days about the looming bond bubble. The negative sentiment is not unfounded. The federal reserve has been running the printing presses for several years now in the name of quantitative easing and the effect has been downward pressure on interest rates, which remain near historical lows. The yield an investor is able to obtain today on a 10-year, default-free bond* is south of 3%. What’s worse, and as we have seen recently, as the central bank threatens to slow its easing program and notional interest rates rise, bond prices fall and investors see red on their statements from an asset that is supposed to be safe. Ouch!
In reality, it’s not as bad as it may first seem. To explain why, I thought it would be instructive to go through a quick bond primer to refresh your knowledge on fixed income assets and why they behave the way they do. First, I will review why bond prices fall when interest rates increase and second, I will explain why this doesn’t matter as long as you have a sufficient time horizon.
Generally speaking, when interest rates rise, bond prices fall. This occurs because, after a rate rise, investors can now buy newly issued bonds with similar characteristics as a formerly issued bond, but obtain a higher coupon. For example, let’s say I purchased a bond last month for $100 that promised to pay me $3 each year (the coupon) for the next 10 years before giving me my $100 back. I now own a bond on which I can expect a 3% yield until it matures a decade from now. As long as the government (or company) that I have lent this money to does not go bankrupt, I can be assured that I will receive this 3% per year return on my money – virtually guaranteed.
What if, soon after purchasing my bond, rates suddenly go up to 4%? Investors can now buy similar bonds for $100 and receive $4 a year when I’m only entitled to $3. My bond is now inferior to the bonds being sold today and hence, if I wanted to sell it, I would have to offer my bond at less than the $100 I paid for it. How much less? Perhaps not surprisingly, the price of my bond will drop in value to a point that makes the price plus the annual $3 coupon payments exactly equal to the 4% bond being issued today.
Did I actually lose money on the bond I purchased? Well, that all depends on whether I have to sell it. If I plan to hold my bond to maturity (and there is no bankruptcy), I will receive just what I was promised: $3 a year in interest and my $100 back at the end of the contract. In fact, my actual return may be higher if I took those $3 payments and reinvested them in new bonds that are now offering a higher yield! My statement, however, values my investments as if I had sold them all on the relevant statement date so it appears as if I did lose. Over the longer term, the value will self-correct. So, after an initial period of feeling sorry about the timing of my purchase, I can rest assured that, in time, I will achieve the yield I was promised when I purchased the bond.
In my next post, I will discuss the real enemy of the fixed income investor – inflation!
*Government bonds issued by stable, developed countries have generally been thought of as default free. There may be some question whether any bond is actually default free today given the recent political debacle in the U.S. where there is a real threat that even America could default on its debt. Nonetheless, we will refer to these bonds as default free for the sake of convention.