In Part I of this two-part series on fixed income, we looked at the various types of bonds and the rating system of three large agencies. In Part II, we'll discuss the interest rate environment, how rising rates affect bond prices and conclude with a few thoughts to consider before interest rates start their ascent.
The Interest Rate Environment
When you hear that interest rates are going to rise, it's important to distinguish at what point(s) on the yield curve this will occur. Here's a sample yield curve to illustrate.
The yield curve consists of a number of maturities ranging from 3 months to 30 years, represented by the horizontal axis. The vertical axis represents the level of interest rates. The yield curve is created by plotting the yield of bonds with various maturities. The exhibit contains three different yield curves. Line A represents a normal yield curve where long-term rates are higher than short-term rates. This is 'normal' because longer maturities should pay a higher yield (to account for the additional risk) than short-term maturities. Line B is an inverted yield curve where short-term maturities are paying more than long-term. Line C is flat.
U.S. interest rates are affected by many issues including supply and demand; the economy; Fed policy; and global events. Here's a brief comment on each.
Supply and demand for U.S. Treasuries is a key issue. Since Treasuries have the highest credit rating and are considered extremely safe, they are the standard by which other bond prices are determined. Therefore, when demand rises the price on Treasuries will rise and yields will fall.
Economic conditions also play a significant role in the movement of interest rates. When the economy slows, investors become more pessimistic and exchange risky assets for safer ones. This increases demand, pushing prices higher and yields lower.
Fed policy has a direct impact on interest rates, primarily at the short end of the yield curve. The Fed establishes the Discount rate which is the rate charged to member banks on loans from the Fed.
The global environment will also impact rates. When fear rises, investors seek a safe haven for their risky assets. Again, U.S. Treasuries are the safest choice. This increases demand causing prices to rise and rates to fall.
Although interest rates are at historic lows and they are expected to rise, it's unclear when this will occur. How much will bond investors lose when rates increase? Let's examine this now.
How Bonds Are Affected When Rates Rise
How much will bonds lose when rates rise? The answer depends on a few variables. For example, bonds with lower coupons and a longer duration will experience the greatest loss. If these bonds also have a low credit rating, the loss will be worse than if it had a higher credit rating. Individual bonds held to maturity are less risky because the investor will receive his original investment back at that time.
That is not the case with a bond fund. When interest rates rise, investors in bond funds may sell as they see the fund's NAV fall. This will cause an even larger loss in the fund. Therefore, an investor in a bond fund has an additional risk (redemption risk) caused by shareholder selling.
Here is a formula you can use to determine the approximate price decline of a bond based on an increase in rates:
BP = – (D x I)
Where BP = bond price
D = duration
I = change in interest rates
