What happens to bond prices when long term interest rates change?
Assume you buy a $1000 bond maturing in 30 years and yielding coupon rate of 4.0% (interest income will be $40.00 per year)
If open market interest rates increase to 4.25%, your bond will be worth (if you want to sell it before maturity) approximately* $941.00 and so on, according to the following table:
Interest Rate Value of Bond
4.25% $941.00
4.5% $889.00
5.0% $800.00
6.0% $667.00
7.0% $571.00
8.0% $500.00
10.0% $400.00
* What your bond will sell for so that the $40.00 interest will equal the yield that a new $1000 bond with similar risk and maturity pays.
Assume you decide that your original 4% yield is sufficient and you’ll just hold your bonds to maturity (or leave them to your heirs when you die). During a time when inflation and interest rates are rising, buying power is decreasing, so that your $40 annual interest income may buy a nice meal at a restaurant today, but perhaps only a hamburger at McDonald’s as time goes by and inflation decreases buying power. Similarly, the $1,000.00 principal you receive at maturity could buy significantly less than it would today. So it’s not the number of dollars you receive that’s important – it’s how much stuff those dollars will buy.
You lose either way – by selling the bond at a loss after interest rates have risen, or holding onto the bond and losing buying power. Holding long term bonds during periods of rising interest rates and inflation can be bad for your financial health.
Of course, the reverse is also true. If open market interest rates go lower (as they seem to be about to do now), the value of your bond goes up, so it can be sold for more than its face value, or what you originally paid for it. With slowing inflation and interest rates possibly falling because of easier Federal Reserve policy, here is what happens to the approximate value of your $1000 bond (with a 4.0% coupon interest rate, as in the example above) as interest rates fall:
Interest Rate Value of Bond
5.00% $800.00
4.00% $1,000.00
3.75% $1,067.00
3.50% $1,143.00
3.25% $1,231.00
3.00% $1,333.00
Bonds can be losing investments when long term interest rates (and inflation) rise, but they can be good investments as interest rates go lower. Remember, though, that all bonds are not created equal. Their market value is also a function of the default risk of the issuer. Triple AAA bonds will have lower yield than B or C- rated bonds because if the issuer fails to pay interest (defaults) or goes bankrupt, the bond can become worthless.