Interest Rates and the Effect on Bond Prices: Prices in Fixed Income Instruments Vary Due to Rate Changes

Author: | Posted in Bond Investing No comments

Interest Rates and the Effect on Bond Prices: Prices in Fixed Income Instruments Vary Due to Rate Changes

This article examines the precise influence interest rates, call features and maturity have on each other.

Interest Rates Affect the Maturity Structure of a Bond Issue

In periods of high interest rates debt issuers usually issue bond projects for a 5 to 10 year duration in the hopes of refinancing the issue when interest rates drop at a lower level. If market conditions allow a very short two year call redemption feature will be added. This is used if interest rates drop suddenly and the savings from a redemption and reissue can be obtained in a longer term issue.

What has occurred is a complex calculation of interest rate effects. If a 30 year bond is priced at maturity, say 8 percent at par, has a 5 year par call, if will behoove the issuer to call that bond should interest rates drop significantly below 8 percent. If long rates move to 6 per cent there is a 2 percent savings for every year that maturity is shortened. The issuer calls the bonds and issues 6 percent bonds. The issuer makes his savings and the bond holder is forced to find another credit to invest in. If he accepts the reduced rate environment he will buy the 6 percent bond and will have reduced his income by one-third. Or he may downgrade his credit requirement and choose a lesser grade credit close to his 8 percent yield. Meanwhile, the issuer is always cognizant of the yield spread between his call date and maturity structure.

On the other hand the bond holder could keep his money short and wait for interest rates to rise again. In the future the bondholder would be wise to buy a discount bond that would pay off at par were it called.

The Effect of Credit Quality on Interest Rates

When bonds are under credit risk during recessionary or inflationary times there is a growing spread differential between the best, highly rated bond credits and the lower rated credits. This makes sense since poor credits have less financial maneuverability, they may be in interest rate sensitive industries, or they may not be successful in conserving cash.

Bond Portfolio Managers Take Advantage of Credit Spread Anomalies

Astute credit purchasers will chart the differences in current and historical spreads between financial instruments and purchase them as they reach historically wide proportions. When this happens it is a good auger that interest rates are bottoming and that the end of the recession or economic turmoil is over. Investors buying these securities hold them until spreads narrow towards historical lows. They reverse the trade, buying better quality instruments while selling the lesser credits. This strategy is often used by portfolio managers obligated to be invested near 100 percent all the time. Mutual fund, insurance companies, and bank portfolio managers regularly swap credit spreads.