How bond prices work

MONEY TALK

There has been a lot of news about rising interest rates in recent months While the Federal Reserve raised its short-term benchmark rate in September, the more impactful change is that long-term rates have risen as well. The yield (interest rate) on the 10-year US Treasury has risen from about 4.7 percent at the end of August to more than 5.2 percent as of early October, its highest level in more than two decades. For investors in medium-and longer- term bonds, this has almost certainly meant a negative return over this period.

It extends a now yearslong downtrend in bond prices.

But why does that happen? Why do rising interest rates lead to negative returns on bonds? And why might you care?

Bond returns matter for almost all typical investors with retirement plans. This is because traditional investment guidance recommends putting more money in bonds as you approach retirement. They are seen as more secure and less volatile than stocks. If you use a target-date fund, for example, it will start with most of its allocation in stocks and gradually become more concentrated in bonds as you approach the target retirement date.

If you don’t understand the mechanics of bond prices, you’re not alone. (The relationship between interest rates and bond prices has long been one of the least understood topics in the FINRA Investor Education Foundation’s National Financial Capability Study.) And if you’re a young person looking to embark on a career in finance, you’ll soon learn that calculating bond prices by hand is going to be one of your first challenges.

INTEREST RATES UP, BOND PRICES DOWN

The reason that rising interest rates can lead to negative bond returns is best explained with an example of a single bond.

Imagine you bought a 10-year US Treasury bond five years ago when the yield was about 1.5 percent ("yield" here means "interest rate."

These are not always the same thing, but that nuance is irrelevant to this example).

Let’s say you bought the bond for $1,000 and it paid you $15 per year in interest, representing that 1.5 percent yield.

Now, five years later, you still own the bond, and it has five years left until maturity, when you get your original $1,000 back.

It still pays $15 per year. But now, the yield on a new five-year Treasury bond is 5 percent. So, another investor looking to buy a bond today can pay the same $1,000 but get $50 interest per year.

Would that investor be willing to pay $1,000 for your bond? Absolutely not! Your bond only pays $15 per year, when they can buy a similar bond paying $50. Therefore, if you wanted to sell your bond, you would need to sell it for significantly less than $1,000. Even though your bond will pay back the full $1,000 in five years, you would only get $850 today if you sold the bond. At that price, the buyer’s $15 a year plus a $150 gain at maturity adds up to roughly the same 5 percent they’d get on a new bond.

If you hold a retirement account that owns a bond fund made up of hundreds of individual bonds, the fund’s value has declined in this same way.

LOOKING FORWARD

Bond values have fallen, and you may have seen this in your retirement plan.

Even as the stock market hovers near all-time highs, you may have noticed a small decline in your retirement account if you have a more moderate portfolio of stocks and bonds.

Moreover, this decline in bond values has been ongoing. Although interest rates have bounced around, the general trend has been upward for the last several years.

Bond investors who started paying attention in the last five years may have experienced a negative total return.

The question I’m therefore hearing from clients right now is, "Why do I own bonds at all?" The stock market has been excellent, and bond prices have fallen. Looking back, bonds don’t seem to be helping.

But let’s not confuse past returns with what the future might be. As interest rates have risen, bonds have become more attractive. Simply put, a bond yielding 5 percent has a higher expected return than a bond yielding 2 percent. Higher interest rates are preferable for forward-looking investors. If yields keep rising, bonds could continue to lose value, but the higher income they pay would help offset that decline.

None of this means rates are done rising, or that you should rush to load up on bonds Nobody knows where interest rates will go from here. But getting rid of bonds now would likely mean selling at a loss. If you are nearing retirement, bonds likely still deserve a place in your portfolio, and today’s higher rates only strengthen that case.

Luke Delorme is director of financial planning at Tableaux Wealth in Stock-bridge. Reach him at (413) 2642404 or Luke@ TableauxWealth.com.

A London Stock Exchange employee points out a bond. In the U.S., as interest rates rise, bonds will see a lower yield return. But financial experts warn this doesn’t mean you should offload your bonds.OLI SCARFF—GETTY IMAGES Luke DelormeMoney Talk

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