Most investors own bonds via mutual funds or a target retirement fund. Bonds are thought of as a very safe investment compared to stocks because their principal amount doesn’t change. If you buy a $5,000, 10 year bond paying 6%, then in 10 years you will get your $5,000 back plus interest. Seems safe enough but what happens if you sell the bond before the term is up?
Bond prices if interest rates rise
What if inflation has taken hold of the economy and interest rates have gone up? What if after 5 years the new government 5 year bonds are paying 10%? Can you still get $5,000 for your 6% bond? Not likely – a new investor with the choice between a new 5 year bond paying 10% and your 5 year (remaining years) bond paying only 6% will undoubtedly choose to buy the higher interest government bond.
The only way that investor is going to consider your 6% bond is if you lower (or discount) the value of the bond so that the combination of capital gain and interest payments will equal the 10% interest payments which are currently available on new bonds.
Please note that all calculations are approximations. I’m also ignoring inflation which is also an important factor.
Since the existing interest payments on your bond are 6% then the investor will need to discount the value of your bond to give him 4% increase per year. If he buys your bond for $4110 and then redeems it after 5 years for the principal amount of $5,000 then this will give him the remaining 4% return. This would only be true if interest rates remain at 10% for new bonds. In actual fact most people would assume they probably wouldn’t.
The opposite effect is observed if interest rates decrease since bond values will increase.
Does this effect hold true for all bonds?
The rule of thumb is that when valuing a bond – the more time until maturity – the more the value of the bond will be affected (good or bad) by current market interest rates. A bond that is going to mature in a year or two will not change much in value if interest rates change. A bond that has a long time before maturity will have large value changes if interest rates change.
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