Typically, bond prices and interest rates move in opposite directions. This means that when interest rates rise, bond prices tend to fall, and conversely, when interest rates decline, bond prices tend to rise.
Suppose you invest $10,000 in a 10-year U.S. Treasury bond with a 2 percent yield. That interest rate is fixed, even as prevailing interest rates change with economic conditions — especially the rate of inflation. After five years, you decide to sell the bond, but interest rates have risen, and similar new bonds are now paying 3 percent. Consequently, no one wants to pay $10,000 for a bond yielding 2 percent when a higher-yielding bond costs the same. The bond’s value has decreased.
When interest rates decrease, the reverse happens. If interest rates had fallen and new Treasury bonds with similar maturities were yielding 1 percent, you could most likely sell your 2 percent bond for more than your purchase price.
When evaluating your bond-related investments, an important piece of information is a statistic known as “duration.” In finance, the duration of an asset that consists of fixed cash flows, like a bond, is the weighted average of the times until those fixed cash flows are received. Duration also measures the price sensitivity to yield, the percentage change in price for a parallel shift in yields. Simply said, the longer the duration, the more sensitive a bond is to changes in interest rates.
Interest rate risk can be simplified by the following statement: when interest rates rise, bond prices fall; conversely, when rates decline, bond prices rise. Therefore, the longer the time to a bond’s maturity, the greater its interest rate risk.
Many investors often put a high percentage of their portfolios in bonds for income or to hopefully generate more stable types of returns. This holds especially true when they are very worried about the economy or other financial issues, or after they have taken a beating in stocks. Unfortunately, in a rising interest rate environment, that logic could present problems.
Julia Carlson is a registered principal with LPL Financial, and securities and advisory services are offered through LPL Financial, a registered investment advisor, member FINRA/SIPC.
Information in this column is for general information only and not intended as investment, tax or legal advice. Please consult the appropriate professionals for specific information regarding your individual situation prior to making any financial decision.
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