Have you ever wondered why your fixed income values decline when interest rates rise? Financial advisors, investment companies, and investors alike have to deal with rising interest rates and their negative effects on fixed income prices. As an independent Certified Financial Planner™ professional, I have been hearing these concerns a lot from financial advisors and prospective clients in Northridge, Sherman Oaks, Calabasas, and throughout California. So, why do rising interest rates negatively affect fixed income prices and what does this mean for your financial investments? Let’s start by examining how interest rate movements affect bond prices.
The Financial Planning of Bond Prices and Bond Yields
Let’s begin with an example to explain how bond prices and bond yields move in relation to one another. Let’s assume you have purchased a 10 year bond (investing $1,000) that pays a coupon rate of 4%. So, now you own a bond worth $1,000 (par value), will be collecting an annual interest of $40 ($1,000 x 4.0% = $40), and will be receiving your principal ($1,000) back in 10 years. Now, let’s assume interest rates have risen to 6% one year after your bond purchase. What happened to the value of your financial investment and why?
Now, bonds are being issued at a 6% coupon, while your bond still has its 4% coupon. This causes your bond’s market value to decline to around $864, why? From the moment bonds are issued, they are constantly being re-priced and traded in the secondary market up until maturity. The reason for these ongoing adjustments in bond prices relative to interest rates can be explained by a bonds’ yield to maturity (YTM). So, what is yield to maturity?
Understanding your Bond Investments and Yield to Maturity
Yield to maturity is the discounted cash flow rate of return earned by an investor who buys a bond at today’s market prices, with the assumption the financial investment will be held to maturity and the investor receives all coupon payments. Basically, yield to maturity is the present value of all a bond’s future cash flows which equates the price of a bond in relation to interest rates.
In this case, as interest rates rose to 6%, your bond’s market value had to adjust downwards to around $864 to compensate an investor for the interest rate shortfall your financial investment offers relative to today’s 6% coupon rates. Because your coupon rate is fixed at 4%, your bonds value decreased enough to make your bonds’ yield to maturity equal to current interest rates of 6%. So, an investor could either invest $1,000 in a 10 year bond paying a 6% coupon rate (with a yield to maturity of 6%) or buy your 10 year bond paying a 4% coupon, with 9 years left to maturity, at a discounted price of around $864 (with an equivalent yield to maturity of 6%). This is called interest rate risk. The yield to maturity of a bond is the reason why bond prices and bond yields move in opposite directions.
The most important thing to remember is that it’s not the coupon rate of the bond that is important. Rather, it is the bonds’ yield to maturity that is most important as that shows you what you will actually get paid from your financial investment up to maturity.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.