The Impact on Bond Pricing in a Changing Interest Rate Environment

Posted: January 24, 2018
Tagged As: Investments

If you’ve recently looked at a financial statement and discovered you've lost money on bonds, you may be wondering how that is possible. 

Of course, there is the simple answer - if interest rates go up, bond prices go down.  However, there is more to it than that.  First, it should be determined if the person (or organization) is holding the bond until it matures, when the principal is due.  If the bond is being held to maturity and the issuer (corporation or government typically) can and will pay in full, then any change in bond price prior to maturity is not a permanent loss, it is only a temporary loss.  If the bondholder must prepare financial statements prior to maturity and show the bond at market value, the bond will show a loss, but will make up the difference at maturity.  Second, if the person holding the bond sells the bond prior to maturity or takes action based on financial statement values for bonds, a loss due to interest rate increases is more meaningful.

Why do Rising Interest Rates Cause Bond Prices to Fall?

Let’s assume the price of a bond is $100 and will mature at $100.  If the market rate for an A rated bond is 4% for a 10-year maturity, the bondholder receives a series of interest payments - usually $2 every six months - and $100 at the end of the tenth year when the bond matures.  With interest rates at 4% the bond is fairly priced at $100.  If the market rate for a similar quality and maturity of bond rises to 5%, what happens?  A bond buyer could buy a bond that pays $2.50 every six months and $100 at maturity and pay $100 now.  If you tried to sell your 10-year bond at 4% for $100, you wouldn’t likely have any takers.  Why would they pay $100 to buy your bond that only pays $2 every six months when they could get a better return (i.e. $2.50 every six months) for their $100?  Obviously they would not.  That means if you wanted to sell your bond, the price would fall, and you would receive less than $100 for it.

Why do Falling Interest Rates Cause Bond Prices to Rise?

Conversely, if interest rates fall, the opposite of the above occurs.  If market interest rates for a comparable quality and maturity fall, then the price for your bond goes up, as the biannual payment of $2 plus $100 at maturity is more than what a buyer would receive for a new bond.  As such, your bond price would rise.

Is There a way to approximate the Gain or Loss from Interest Rate Changes? 

If you’re looking to estimate the impact of interest rate changes on your bond, you can use a measure called “duration.”  If a bond has a duration of 6, it means that if interest rates go up by 1% your bond price falls by 6% (e.g. from $100 to $94) or if rates fall by 1% your bond price goes up by 6% (e.g. from $100 to $106).  It is not perfectly linear, but gives a good approximation. Notice there is no reference to time when discussing duration; duration is measure of interest rate sensitivity.  Duration does increase for longer maturities but decreases with higher interest (coupon) payments.

Why do you Keep Saying “Market Interest Rates for a Comparable Quality & Maturity”? 

Both the quality and maturity of the bond affect bond prices.  For example, if the Bank of Canada raises interest rates by 25 bp (basis points) or 1/4 of 1%, does that mean that my 10-year A rated corporate bond falls in price?  Maybe, maybe not.  Just because the Bank of Canada raised rates by 25 bp doesn’t mean that 10-year risk free (federal government) interest rates rose by 25 bp.  They could rise by more or less, or even fall.  If 10-year rates did not change, your bond price would stay the same, even if the Bank of Canada raised short-term rates.  The other piece here is the quality (in my example, an A rated bond).  Again, the bond holder needs to know whether A rated bond rates increased as much as risk free rates (credit spreads refer to this difference).  For example, if the  Bank of Canada raised rates by 25 bp and risk free rates for all maturities increased by the same amount, but credit spreads for A rated bonds reduced by 25 bp, there would be no net change for the interest rate for a 10-year A rated bond and therefore no price change.

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