With interest rates driven nearly to zero by the Federal Reserve, more investors are breaking into bonds.
The Relationship Between Bond Prices and Interest Rates
Bond prices move inversely to interest rates. When interest rates go up, bond prices go down, and conversely, when interest rates go down, bond prices go up. For example, say a bond is issued for $10,000 for five years with a 6% coupon or interest rate, paid semi-annually. Assume that interest rates rise to 7%. If trying to sell this bond, who would buy it when it is paying 1% less than market rates? An investor could just go on the secondary market and buy a similar bond paying 7%.
The bond holder would have to sweeten the deal somehow so to attract a buyer. Maybe the seller would like to hike up the interest rate, but can’t since it’s fixed at 6%. However, the bond selling price can be changed. The annual payment of 600 (10,000 X 6%) has to equal a 7% payment of the selling price of the bond. The value of the bond will then decrease, or be discounted, to $8,571. ((600 = 7%*X), so X, or the bond price, equals $8,571.)
Duration Determines Bond Risk
A reliable way to gauge bond risk is by duration, defined as the change in a bond’s price when interest rates change up or down by one percentage point. Say a bond is owned with duration of 5; its price will go up 5% if indeed interest rates fell by one percentage point. Equally true, if interest rates rise by one percentage point, the bond will lose 5%.
To dirty the water further, as bond prices rise, so does duration. So, if interest rates increase, bond prices are going to drop even further. Since last year the duration of Treasury bonds has increased and is now about 7. And, the duration on municipal bonds has risen to about 8.
Assume that interest rates rise by one percentage point. Also assume $20.000 was invested. $1,400 will be lost on your Treasury bond investment, and $1,600 on your municipal bond investment.
Treasuries Versus Corporate Bond Risk
For Treasury bonds, the main form of risk is rising interest rates. For corporate bonds how well the underlying assets are doing represents another form of risk: there is always the risk that the company will default.
The riskiest bonds right now are Treasury bonds. In an economy coming out of a recession, with interest rates rising, Treasuries are going to take a beating.
Corporate bonds prices, of course, are going to decrease as well, but with a booming economy, the spread between corporate bonds and Treasuries should narrow, cutting your losses.
“Duration—A complete definition.” web.streetauthority.com/terms/d/duration.asp