Understanding Bond Prices and Interest Rates

Bonds provide an element of stability that offsets some of the volatility of stocks. However, they are vulnerable to economic changes that can undermine their value. The biggest economic threat to bonds is rising interest rates. If you own a bond and interest rates go up, the value of your bond on the open market, with few exceptions, will go down. Of course, if you plan to hold the bond to maturity the value of your bond doesnt change because interest rates change. Youll still get the amount promise when you bought the bond, all other things being equal. However, if you plan to own bonds for investment purposes that is you buy and sell bonds as you would stocks - then interest rates are very important.

Bond Prices
Bond prices move inversely to interest rates. When interest rates go up, bond prices go down and when interest rates go down, bond prices go up. Remember, were talking about previously issued bonds trading on the open market. The inverse relationship is easy to see with this simple illustration.

A bond is issued for $10,000 for five years with a 5% coupon or interest rate, paid every six months. Then interest rates rise to 6%.

If you want to sell this bond, who would buy it when it is paying 1% below market rates (5% vs. 6%)? You have to sweeten the deal so the buyer gets a market rate for the bond.

You cant change the interest rate on the bond. Thats fixed at 5%. You can, however change the price you will take for the bond.

The annual payment of $500 ($10,000 x 5%) must equal a 6% payment. Doing the math, you discover that the face value of the bond must be discounted to $8,333 so that the $500 fixed payment equals a 6% yield on the buyers investment ($8,333 x 6% = $500).

If interest rates went down instead of up, you could then sell your bond at a premium over face value because the fixed interest rate would be higher than the market rate.

Illustration
PLEASE NOTE: This is just an example to illustrate the relationship between interest rates and bond prices. It does not represent an actual computation. To do this calculation correctly would require a more complicated process and the answer would be different. However, the seller would still have to discount the face value of the bond to compensate for the interest rate difference. As I noted above, none of this matters if you plan to hold the bond to maturity. Changing interest rates have no effect on existing bonds unless you plan to buy or sell them in the open market.

Conclusion
Because of the interest rate risk, bonds with longer terms are more than bonds with shorter terms. If you plan to trade bonds, be sure you understand the interest rate risks involved and how holding long-term bonds increases that risk.

Italy pays record rates at bond sale

Italy raised nearly 3bn from bond sales on Thursday but was forced to pay record interest rates in a make-or-break government debt auction that was seen as a key test of investor confidence in the eurozone. The auction was seen as crucial for the eurozone after a turbulent week that has sucked Italy into the euro debt crisis amid concerns about its high levels of debt. The sale came as Italys parliament prepares to vote over the next two days on a three-year 40bn austerity package to eliminate the budget deficit by 2014 Opposition parties have said they will co-operate with Silvio Berlusconi, prime minister, to ensure that the package of cuts passes through parliament in record speed with a final vote in the lower house on Friday. The upper house or Senate will vote later on Thursday on proposals . The 1.72bn sale of 15-year bonds was nearly 1.5 times subscribed indicating there was still appetite for the countrys debt, but the 5.9 per cent yield was the highest on record. The 1.25bn five-year bond sale was nearly two times subscribed, while the yield, at 4.93 per cent, was the highest paid at auction in three years In the benchmark five-year maturity Rome had to pay yields of 4.93 per cent versus 3.9 per cent on June 14, a sharp increase in premiums that highlights the dangers for the eurozones biggest government bond market. The fact Rome had to pay high premiums to attract demand is a sign that the eurozone woes are far from over. Gavan Nolan, analyst at Markit, the data provider, said: The bid-to-cover ratios were relatively strong, but the yields were very high. The market seems to be focusing on the latter. The support of domestic accounts will also be crucial throughout the day. Italys spreads are now wider than pre-auction levels. Gary Jenkins, head of fixed income at Evolution Securities, said: While it is good news that they got it done, the rising trend in yields is of some concern.

Italy is not so much too big to fail as too big to bail, so it is very important that yields stabilise. Following the auction yields on the benchmark 10-year Italian government bond rose 7.5 basis points to 5.64 per cent. The Italian credit default swaps rose 8 basis points to 290bps, meaning the cost of insuring $10m of debt a year for five years rose $8,000. In the equity market, Italys FTSE MIB index, which had been recovering earlier in the session, fell 1.6 per cent to 18,551.44. Italy has to refinance hundreds of billions of bonds over the next three years and higher borrowing costs or yields will put extra strains on its already sluggish economy.

Rising Rates and Your Investments

What You Should Know The bond markets are extremely active, with interest rates constantly changing in response to a number of factors including changes in the supply and demand of credit, Federal Reserve policy, fiscal policy, exchange rates, economic conditions, market psychology and, above all, changes in expectations about inflation. Currently, rising interest rates and expectations for economic recovery are impacting bond prices. As interest rates change, so do the values of all bonds in the marketplace. If you are thinking about buying bonds, or have recently bought some, you need to be aware of the effect of rising rates on your holdings. Here are some questions you should consider.

Question Now that interest rates have started to rise, how will that affect bonds?

Answer Interest rates, which recently hovered at their lowest levels in 40 years, are rising. Just as bond prices go up when yields go down, the prices of bonds you own now will generally drop as yieldsinterest ratesgo up.

Question When rates go up, do all bonds lose the same value?

Answer

No, changes in interest rates don't affect all bonds equally. Generally speaking, the longer the bond's maturity, for example a bond that matures in ten years versus another that matures in two years, the more it's affected by changing interest rates. A ten year bond will usually lose more of its value if rates go up than the two year note. Also, the lower a bond's "coupon" rate, the more sensitive the bond's price is to changes in interest rates. Other features can have an effect as well. For example, a variable rate bond probably won't lose as much value as a fixed rate security.

Question What should I do as interest rates rise? Should I hold onto my bonds or sell them?

Answer If you buy a bond and hold onto it until it matures, which many investors do, rising rates won't have any effect on the income you receive. You simply redeem your maturing bond and get back par, or the face value, of the bond. In the meantime, you will continue to earn or accrue interest at the rate you expected when you bought the bond. Here's an example provided by Bloomberg, LP: Example #1: Buy and Hold You buy a 10 year U.S. Treasury Note with a face value of $1,000 and an interest rate of 4.26%. If you keep the bond until it matures, you'll receive $42.60 each year for ten years, plus the original $1,000.

Question What happens if rates go up and I need to sell my bonds? Answer

If interest rates go up and you need to sell your bonds before they mature, you need to be aware their value may have gone down and you may have to sell at a loss. Remember bond prices move in the opposition direction as yield. Here's an example again provided by Bloomberg, LP:

Example #2 Sell before Maturity & Interest Rates have gone up. An investor buys a 10 year U.S Treasury Note with a face value of $1,000 and an interest rate of 4.26%. If the investor sells the bond before it matures and interest rates have risen 2%, he or she would only receive $863.34 (plus any interest paid before the sale). Question At some point, though, rates will go down. What will happen if I sell then? Answer If interest rates have gone down since you bought your bonds, the value of your bonds will have actually gone up, giving you what's known as a "capital gain." That's because your bond is worth more. Here's another example using the Bloomberg data:

Example #3 You Sell Your Bond Before It Matures & Interest Rates have gone down. You buy a 10 year U.S. Treasury Note with a face value of $1,000 and an interest rate of 4.26%. If you sell your bond before it matures and interest rates have dropped 2%, you will receive $1,118.54 (plus any interest paid before the sale).

Question What happens to my bond fund if interest rates rise? Answer

Since a bond fund doesn't have a specific maturity date, the chances are the fund's total return will go down. Total return encompasses both change in prices and interest rate payments. If interest rates rise, the values of bonds held by the fund would fall, negatively affecting total return. However, the fund will continue to receive interest payments from the bonds it holds and will pass them along to investors regularly, maintaining current yield. Bond fund investors also enjoy professional management and asset diversification. Question Besides rising interest rates, are there any other risks I should consider? Answer Yes, virtually all investments carry some degree of risk that you might lose some or all of your investment. When investing in bonds other than government-guaranteed securities, it's important to remember that an investment's return is linked to its credit as well as market changes. The higher the return, the higher the risk. Conversely, relatively safe investments offer relatively lower returns. Bond choices range from U.S. Treasury securities, which are backed by the full faith and credit of the U.S. government and are free from credit risk, to bonds that are below investment grade and considered speculative. In assessing your tolerance for risk, ask yourself, "What will I do if my investment is not there when I need it?"

Question Should I buy bonds now? Answer Most personal financial advisors recommend that investors maintain a diversified investment portfolio consisting of bonds, stocks and cash in varying percentages, depending upon individual circumstances and objectives. You need to be aware of the risks, particularly now, of rising interest rates. But if you are planning to buy bonds and hold them to maturity, they will provide a predictable stream of payments and repayment of principal. Many people invest in bonds to preserve and increase their capital or to receive dependable interest income. Whatever your investment goals-saving for your children's college

education or a new home, increasing retirement income or any of a number of other worthy financial goals-investing in bonds can help you achieve your objectives.