After a bond is issued it continues to trade in the open market. Its price and yield will constantly change to stay in line with current interest rates. Falling rates will result in a bond rising in value; rising rates lead to a bond’s value declining.
Over the past five years, volatile stock markets have triggered a massive shift from equities (stock investments) to bonds, including exchange-traded bond funds and bond mutual funds, as investors have sought to reduce the level of risk in their portfolios. This move pushed up bond prices and lowered bond yields, a bond’s annual interest amount expressed as a percentage of its current value.
Often overlooked by investors, investment grade bonds, which exclude guaranteed investments such as Canada Savings bonds, are interest rate sensitive. As a result when interest rates increase, the bond’s value drops and yield will rise; the opposite changes occur when interest rates fall. With interest rates at historical lows and the economy recovering, a prolonged rise in interest rates and corresponding decline in bond prices seems inevitable.
Unfortunately, many Canadian investors do not understand how bonds work or the risks involved. Without this knowledge investors may suffer significant losses to their portfolios before they even realize what has happened.
When a bond is purchased, the buyer, or bondholder, is in effect lending money for a specific period of time to the borrower, or bond “issuer”. Under the terms of the bond, the buyer will receive the loan amount, the “face value” of the bond, at its maturity, plus regular interest payments through to that date.
What most investors fail to understand is that after a bond is issued it continues to trade in the open bond market. Its price and yield will constantly change to stay in line with current interest rates. While falling rates will result in a bond appreciating in value, rising rates will lead to a bond declining in value, or selling at a “discount”.
Consider what happens to a bond having a value of $1,000 and a coupon rate of four per cent (thus paying $40 annual interest) when interest rates rise. At that point, an investor may be able to purchase a similar bond having a five per cent coupon (and paying $50 in interest annually). Since the coupon rate on a bond does not change, it is the original bond’s price which must fall, as the interest received is less than what a new investor would receive from a bond purchased at the current rates. The amount by which a bond will drop in value is primarily determined by the bond’s maturity date: the longer the bond has to its maturity the greater the drop in value.
The standard means by which to estimate a bond’s likely movement in response to a change in interest rates is “duration”. Denoted in years, duration takes into account a number of factors about a bond, including its maturity.
The higher the “duration” number, the greater the sensitivity of a bond to changes in interest rates. The general rule is that for every one percentage point move up or down in interest rates, a bond’s price will move inversely by a percentage equal to that of its duration. A bond six years from its maturity will thus decrease in value by six per cent when there’s a one percentage point rise in interest rates.
Limit the risks
The duration of bonds held within a mutual fund or exchange-traded fund can readily be found in the fund’s fact sheet or by checking the fund company’s website. Free online calculators may be used to calculate the duration of an individual bond.
While there are many benefits from investing in bonds, investors need to understand how bonds work, their risks, and the investment strategies that can be employed to minimize the risks – related to interest rate changes, inflation and credit arrangements.
Great attention must be paid to both the original construction and regular rebalancing of a portfolio that is custom tailored to an indivual’s risk tolerance and financial goals. The use of a financial professional is recommended.
Darryl Prociuk is a registered financial planner and may be contacted at email@example.com.