why do rising interest rates hurt bonds
When you buy a bond, either directly or through a mutual fund, you're lending money to the bond's issuer, who promises to pay you back the principal (or par value) when the loan is due (on the bond's maturity date). In the meantime, the issuer also promises to pay you periodic interest payments to compensate you for the use of your money. The rate at which the issuer pays you the bond's stated interest rate or coupon rate is generally fixed at issuance. An inverse relationship When new bonds are issued, they typically carry coupon rates at or close to the prevailing market interest rate. Interest rates and bond prices have an inverse relationship; so when one goes up, the other goes down. The question is: How does the prevailing market interest rate affect the value of a bond you already own or a bond you want to buy from or sell to someone else? The answer lies in the concept of opportunity cost. Investors constantly compare the returns on their current investments to what they could get elsewhere in the market. As market interest rates change, a bond's coupon rate which, remember, is fixed becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself. Let's look at an example. Suppose the ABC Company offers a new issue of bonds carrying a 7% coupon.
This means it would pay you $70 a year in interest. After evaluating your investment alternatives, you decide this is a good deal, so you purchase a bond at its par value: $1,000. Interest rates and bond prices have an inverse relationship What if rates go up? Now let's suppose that later that year, interest rates in general go up. If new bonds that cost $1,000 are paying an 8% coupon or $80 a year in interest buyers will be reluctant to pay the $1,000 face value for your 7% ABC Company bond. In order to sell, you'd have to offer your bond at a lower price a discount that would enable it to generate approximately 8% to the new owner. In this case, that would mean a price of about $875. What if rates fall? Similarly, if rates dropped to below your original coupon rate of 7%, your bond would be worth more than $1,000. It would be priced at a premium, since it would be carrying a higher interest rate than what was currently available on the market. Of course, many other factors go into determining the attractiveness of a particular bond: the length of time until the bond matures, whether or not its interest is taxable, the creditworthiness of its issuer, the likelihood that the issuer will pay off debt early, and more. But the important thing to remember is that change occurs in market interest rates virtually every day.
The movement of bond prices and bond yields is simply a reaction to that change. 1. This hypothetical illustration assumes a 7% coupon, $1,000 face value, and a 10-year maturity. The illustration is approximate and is not intended to represent the return of any particular bond or bond fund. Bond values fluctuate in response to the financial condition of individual issuers, changes in interest rates, and general market and economic conditions.
Investments in high-yield bonds (sometimes referred to as Бjunk bondsБ) offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a junk bond issuerБs ability to make principal and interest payments. Income from investing in municipal bonds is generally exempt from Federal and state taxes for residents of the issuing state. While the interest income is tax-exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the Federal alternative minimum tax (AMT). Companies may reduce or eliminate dividends to shareholders. Historically, dividends make up a larger percentage of a stockБs total return.
This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. The investments discussed have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U. S. or abroad. All sector and asset allocation recommendations must be considered by each individual investor to determine if the sector is suitable for their own portfolio based upon their own goals, time horizon, and risk tolerances. Investing in fixed income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa. Investments focused in a certain industry may pose additional risks due to lack of diversification, industry volatility, economic turmoil, susceptibility to economic, political or regulatory risks, and other sector concentration risks.
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