The ups and downs of the bond market aren’t typically as dramatic as stock market fluctuations. However, this isn’t always the case, as we’ve seen so far in 2022. The Federal Open Market Committee has started raising the federal funds rate and plans to continue to raise it further, which has caused bond prices to fall quickly and sharply.
Interest rate changes can have a big impact on holders of interest-bearing investments, like bonds. Fortunately, the impact tends to be short-lived as everyone adjusts to the new interest rates.
Why are bond prices sensitive to interest rate changes?
Bond prices and interest rates have a negative correlation – as one goes up, the other typically goes down. We are seeing this now as interest rates are rising, bond prices are falling. Why does this happen? New bonds with the higher yield are more appealing to investors. Bonds that investors may be currently holding are still paying them interest, but the bond itself is worth less on paper now that there are other bonds to invest in that are paying a higher interest rate.
For example, say you hold a $1,000 bond that pays 2% interest, or $20. However, interest rates have increased and newly issued bonds are now yielding 4% interest. What does that mean for your bond holding? Effectively, your $1,000 bond is now worth only $500. Why? No one wants to pay $1,000 for your bond that generates $20/year when they can pay $500 for a newly issued bond and still make $20/year.
What can you do when bond prices have fallen?
When a bond is held to maturity (and the issuer does not default), the owner of the bond receives the face value of the bond, plus interest earned. Using the previous example, even though your bond holding’s value is worth less compared to other bonds available, you still get the $1,000 principal back plus interest.
Depending on a several different factors, there may be opportunities to sell your bond before it’s maturity date. It may make sense to sell early and invest your money in a bond that pays more interest. One of the factors to consider in assessing whether to sell a bond early is the bond’s duration.
What is duration?
Duration is a measure of interest-rate sensitivity for bond investments. It measures how many years it will take for an investor to recoup the bond’s price from the bond’s total cash flows. In general, the longer the duration, the more sensitive that bond is to interest rate fluctuations.
For example, let’s say you have invested $1,000 in two separate bonds. They are both 8-year corporate bonds. Bond A pays 3% interest and Bond B pays 5% interest. Bond B will have a slightly shorter duration because the investor is recouping her original $1,000 investment faster with Bond B and it’s higher coupon rate.
A common approach to investing during times like these is to hold short-term bonds that have a low duration. Short-term bonds are less sensitive to interest rate changes compared to long-term bonds. It also allows you more flexibility to buy new bonds as interest rates continue to rise. For long-term investors, higher yields on reinvested cash flows can outweigh the initial market price decline that bonds face as yields rise.
The bottom line
Bonds work differently than stocks. It can be stressful when both stocks and bonds in your portfolio are down. It has been a bleak start to 2022, but remember that as interest rates rise, the yields on your bond investments rise too. Please contact us if you have questions about your investments and/or if you would like a second opinion.
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