Potentially one of the most effective areas of risk for investors these days has got to be bonds and fixed income investments. There are various key reasons for this, but the one that is most relevant to nearly all investors is the risk of rising interest rates. The best way to illustrate why investors need to care about risking interest rates is to consider today’s 30-year bond, which is currently trading at a yield of 4.44 %. What this says us is that investors who invest $ 200,000 in a 30-year government bond will receive $ 8,880 in income.
As rates increase, your $ 200,000 bond will continue to yield $ 8,880, so there is no risk to your income. However, if your neighbor decides to invest after rates have increased to say, 5.25 %, then your neighbor will be earning $ 9,250 when he or she invests his or her $ 200,000. In other words, for the same amount of money, your neighbor will earn more than you will.
Now, let’s suppose that by the time rates get to 5.25 %, you are hit with a large (okay, an excessively big) repair bill. You need $ 200,000, but your stocks are not trading where you would like them to and your term deposits are still locked in for number of years. But here you have this very marketable government bond.
If you had to trade your $ 200,000 bond that provides income of 8.88 % at a time where current rates are yielding 5.25 %, you will have to take a hit on your bond sale. That means selling your $ 200,000 for less than the $ 200,000 you paid for it.
You may wonder why would anyone do this when all they have to do is wait until their maturity date to take delivery of the full face value of their bond. Well, in order to entice other investors to buy your bond at 8.88 % instead of another bond that pays a better return, you will need to discount your price so that the capital gain they will realize (e.g. the difference between what they pay for your bond and its face value) combined with the income over the years will yield the same or close-to the current bond-market yields.
We see this type of discounting every day. We see it with cars that have more mileage than new cars, we see it with homes in less desirable areas. And of course, the same holds true if rates drop ; bond holders can demand a premium for their bonds because their income is higher. Again, we see premiums being paid on all sorts of things, particularly rare, collector items (and bonds that pay attractive income in periods where income streams are dropping are indeed rare!) .
Understanding this inverse relationship between rates and bond prices is not always an easy one. But investors need to be familiar with this relationship fairly quickly, particularly at times like these when rates are poised to increase.
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