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This post is part of a larger mini-series called The Ultimate Guide to Understanding Bonds. You can read the rest of it over here.
You’ve doubtless heard that any change in the interest rate is tightly coupled with price movement in the bond market. How exactly does the relationship work?
Bonds In a Declining Interest Rate Environment
Let’s start with a declining interest rate environment. In the US, we have been in a declining interest rate environment for almost 35 years. See for yourself.
Source: Federal Reserve Board of Governors via FRED.
Bond Prices Increase
In a declining interest rate environment, bond prices increase. Pretend you are a buyer of bonds for now. Last year, your fellow lenders bought a $100 bond that pays them $5 a year, or 5%. Now the interest is only 4%, meaning you can buy a $100 bond and make only $4 a year in interest. That bond from last year sure is looking attractive. So you approach the holder of one of these bonds and ask to buy it from him. He probably won’t sell it to you for exactly what he paid, but you sweeten the pot a little. You’ll buy it from him for $105. Getting $5 a year in interest, you’re going to be earning $5/$105 = 4.7% interest, still way better than newly issued bonds even if you have to pay a premium.
In a declining interest rate environment, bond prices will increase until the return on cushier bonds roughly equals that of newly issued bonds.
Loans Get Called
You know from our earlier discussion that some bonds have provisions that allow a borrower to call their loan, or basically end the loan at some period before the maturity date. The window for this is specified in the bond contract and can vary; some bonds are not callable. In a declining interest rate environment, borrowers look around and realize the loan they’ve got outstanding isn’t very attractive anymore. They’d rather refinance. Because of this, you see higher call rates in a declining interest rate environment. This tends to happen not in the short term but in the medium to long term. As a bond purchaser, this is bad news for you. You’ll get your cash back sooner than you might have expected and now your options to redeploy that money are less attractive because the going interest rate is much lower.
It’s great to be an existing bondholder in a declining interest rate environment. You either get to clip a higher coupon than your peers for many years, or you can choose to cash in and sell your bonds at a premium to an incoming investor.
Bonds In A Rising Interest Rate Environment
In a rising interest environment, you can expect to see the opposite of what we just discussed.
Bond Prices Decrease
If you’ve got money burning a hole in your pocket and go out to the market to buy some bonds, you can go year-old bonds which were written for a 5% return: $100 bond paying $5 of interest a year. Or you could buy newly issued bonds that are paying 5.5%: $100 paying $5.50 a year. Joe Schmoe comes along and wants to sell you a bond that pays $5 a year. Well, you certainly aren’t going to buy it at par value vs a newly issued, higher interest rate bond. But if he’d sell it to you for $91, then $5/$95=5.5% interest per year for you, equivalent to the new going rate.
Because of this, bond prices decrease in a rising interest rate environment.
Limited Call/Refinancing Activity
Borrowers look around and realize that the loan they have is pretty sweet. You as the bond holder would love for them to call the loan so you can go out and buy newly issued bonds at a higher interest rate, but your borrowers aren’t dumb. Y’all are stuck together until the maturity date, or unless the trend in interest rates reverses.
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