What Happens to Bonds When Interest Rates Rise?

My article last week “Look Out Below…For Bonds!” raised a lot of eyebrows and prompted a number of questions regarding what happens to bonds when rates do rise.
The bottom line is that rising rates are bad for bond holders. For example, let’s assume you have just purchased a 5% bond maturing in 5 years, at par (par is $1,000). At this moment, the bond is valued at its exact worth, not more or less.

For your purchase, you will receive annual interest of $50 ($1,000 x 5.0% = $50), until maturity when you will receive your principal back.

All the way up until maturity the value of your bond will fluctuate after your purchase as interest rates rise or fall.

So, what happens when rates rise? Let’s assume that interest rates rise to 7.0%. Because new bonds are now being issued with a 7.0% coupon, your bond, which has a 5.0% coupon, is not worth as much as it was when you bought it. Why you might ask?

If people invest the same $1,000 per bond that pays a higher interest rate, why would they pay $1,000 for your lower interest bond? Your bond would be less than $1,000 which is known in the market as trading at a discount.

On the other hand, if interest rates drop after your purchase, the value of your bond would go up because investors cannot buy a new issue bond with a coupon as high as yours. Therefore, your bond would be worth more than $1,000, known as trading at a premium. The bottom line is this…

If you hold it until maturity you will receive your principal back.

What happens to Bond Funds?

Plain and simple, bond fund investors get a double whammy. First, bond funds are perpetual, constantly buying and selling, rarely waiting until maturity. Therefore, there is never a “return of principal”.

Second, when interest rates rise, bond fund holders sell their shares. The fund manager at this point may be forced to sell bonds prematurely in order to raise enough cash to meet the fund’s redemption requests. This can be devastating to a bond fund and create additional risks. Redemption risk exaggerates the pain for those who remain in the fund.

Invest Tactically in both stocks and bonds!

My main concern is that with interest rates so low, who wants to lock in a bond which would just about guarantee a loss on your investment after inflation? Clearly no one. That’s why it is so important to manage your portfolio “Tactically”, never buy and hold. This is the only way you actively manage your assets to where the opportunities are for the future, not the past.

Read my latest special report: The 3 Styles of Money Management – Which is right for you?

Feel free to contact me with any comments or questions.

Cheers -Keith
916-925-8900

Visit My Other Sites

Please click here to download SFA Disclosures, privacy policy and business continuity plan. Springer Financial Disclosures. Springer Financial Advisors ("Advisor") is a federally registered investment adviser located in Sacramento, California. Advisor and its representatives are in compliance with the current filing requirements imposed upon registered investment advisers by the Securities and Exchange Commission and the State of California. Advisor's web site and its emails of general distribution are limited to the dissemination of general information pertaining to its advisory services, together with access to additional investment-related information, publications, and links. Accordingly, the publication of Advisor's web site on the Internet or dissemination of informational emails should not be construed by any consumer and/or prospective client as Advisor's solicitation to effect, or attempt to effect transactions in securities, or the rendering of personalized investment advice for compensation, over the Internet. A copy of Advisor's current written disclosure statement discussing Advisor's business operations, services, and fees is available from Advisor upon written request. You may also obtain publicly available information about Advisor through the SEC website as follows: http://www.adviserinfo.sec.gov/IAPD/Content/Search/iapd_OrgSearch.aspx. Advisor does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to Advisor's web site or incorporated in an email, and takes no responsibility therefore. All such information is believed to be reliable and authoritative but does not constitute sufficient information to be the sole basis for sound investment decisions and all users thereof should be guided accordingly. Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended or undertaken by Advisor) made reference to directly or indirectly by Advisor in its web site, email, or indirectly via a link to an unaffiliated third party web site, will be profitable or equal the corresponding indicated performance level(s). Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client or prospective client's investment portfolio. Certain portions of Advisor's web site (i.e. articles, commentaries, etc.) may contain a discussion of, and/or provide access to, Advisor's (and those of other investment and non-investment professionals) positions and/or recommendations as of a specific prior date. Due to various factors, including changing market conditions, such discussion may no longer be reflective of current position(s) and/or recommendation(s). Moreover, no client or prospective client should assume that any such discussion serves as the receipt of, or a substitute for, personalized advice from Advisor, or from any other investment professional. The term, qualified retirement advisor is not an official designation. The information is of a general nature and should not be applied indiscriminately to particular situations wherein it may not be completely applicable. Advisor is neither an attorney nor an accountant, and no portion of the content should be interpreted as legal, accounting or tax advice. Keith Springer, SFA’s President, provides investment commentary as host of “Smart Money with Keith Springer” on KFBK NewsRadio AM 1530. Smart Money with Keith Springer is paid for by SFA and is deemed advertising by the Securities and Exchange Commission.

           

Click Here To Get Your Free Customized Retirement Income and Tax Strategy Analysis