Wednesday, August 12, 2009

Bond Math: High Coupons versus Low Coupons

Recently we have had a few people ask us why we are buying larger coupon rather than smaller coupon bonds and it became evident that many don't understand the effect rising interest rates can have on a bond portfolio. Here is a good example of the price change rising interest rates can have on a bond portfolio:

Let's imagine there are two bonds in the market, both by the same issuer. One bond is a 7% coupon due in 2029 and the other is a 5% coupon due in 2029. Let's also imagine that both are trading at 6% yield to maturity. Now let's move out one year from today...and let's imagine that interest rates have moved up. Let's imagine that both these bonds have now moved to a 7% yield to maturity...so their prices have fallen.

The price of the 5% coupon bond has fallen approximately 10.75%...but the price of the 7% coupon bond has fallen only 10%. In other words, with the same rate of change in interest rates, the lower coupon bond has changed more in price relative to its original price than the higher coupon bond has changed relative to its original price.

What does this mean for the investor's portfolio? Well, for a $1mm portfolio, it means that our decision to buy a larger coupon bond rather than a smaller coupon bond just saved the investor $7500 in portfolio losses.

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