What happens to my bond when interest rates rise?
Narrator: Rising interest rates are not good for bond prices. That’s because the price of existing bonds goes down when interest rates rise. Yes, that’s counterintuitive.
Most people think that higher interest rates should be good for bond investors.
Jack: What’s that? Narrator: It’s a preferred share! It’s a Floating Rate Note! No wait, it’s Uncle Pipeline!
Uncle Pipeline: Hey there! I heard you were having some trouble understanding the way interest rates – also referred to as yields – affect bond prices! Allow me to break this one down for you, Jack. Let’s say you bought a 10-Year Treasury Bond in June 2016, when bond yields bottomed.
At the time you paid $100 and locked in that 1.5 per cent coupon – or $1.50 per year. When yields recently hit three per cent, a bond investor who just bought a newly issued bond was getting $3 coupon per $100 of his bond. If you wanted to sell the bond that you have owned for 2 years you’re not going to get what you paid for it.
Because think about it.
Why would someone pay Jack $100 for a bond that pays 1.5 per cent or $1.50 when they could just buy a new U.S. Treasury bond at the prevailing market yield of 3 per cent and get paid $3. Obviously other investors would only buy your bond at a lower price that gave them the same yield as a newly issued bond.
Jack: Aw darn Uncle Pipeline: Working out the bond math, your bond would now be worth $90.
That’s because – you guessed it – prices of existing bonds go down when interest rates rise. The opposite is also true: when interest rates fall, bond prices go up.
Let’s look at an actual 10-Year Treasury Bond. This bond has a 2.25 per cent coupon and matures in 10 years.
The teeter-totter is flat when the yield to maturity investors demand is the same as its coupon – 2.25 per cent. We can see the bond is priced at par – $100. But what happens to the price of this bond if investors now demand a yield to maturity 1 per cent higher. When its yield increases one per cent to 3.25 per cent, the price drops to $92.
Inversely, we see that when the yield to maturity investors demand decreases one per cent to 1.25 per cent, the price increases above par to $108. Now Jack, do you see what that inverse relationship does to your bond price? That’s why the interactions between bond yields and bond prices are important to understand when you’re trying to figure out if you’re making a good investment. Jack: Thanks Uncle Pipeline