Thursday, May 3, 2012

The Rise and Fall of Bond Prices

It has been over a year since we've discussed rising interest rates and falling bond prices. As the economy begins to improve, interest rates will begin to rise which means bond prices will fall. The question we hear most often is "What will happen to bond prices when interest rates rise?"

The quick answer is that bond prices will fall. But, does that mean one should sell his or her bonds and move into money market and wait for rates to rise? Let's take a look at what happens to bonds due in 10 years when rates rise 3% over the next 5 years:
Right now, there are a number of 10 year corporate bonds which can be purchased at approximately 3.92%. That means that a person who holds one of these bonds until maturity will get an annualized return of 3.92% for the 10 year period the person holds the bond. In simple terms, that person obtains over 39.2% total return on the original investment at the end of the 10 year period. 

Now, if interest rates rise over the next 5 years from 3.92% to 6.92%...would someone have been better off waiting in cash for 5 years and then investing? Well, 6.92% over the remaining 5 years gives that person a 34.6% total return versus the 39.2% we saw earlier with someone who accepted 3.92% for all 10 years. 
No, in this case the person is better off investing at 3.92% for 10 years than waiting for 5 years in cash and then investing for 5 years at 6.92%.

What will happen to the price of a 10 year bond if rates are up 3% in 5 years? Well, remember, that bond will come due worth 100 cents on the dollar in 10 years, but yes, the price will vary during those 10 years if rates change.

If rates go to 6.92% in 2017 (5 years from now) on bonds due in 5 years, then the above bonds will be down in price (temporarily) approximately 12%. Again, that price fall will be temporary, but there will be a price drop nonetheless.

The temporary price variance is quite dramatic if one were looking at 20 or 30 year maturity bonds, which is why at this point we continue to like the 10 year sector of the yield curve. Risk/reward is good, liquidity is good, and interest rates are very competitive.