Bond Basics - Interest Rates
February 1st, 2010 |
As a bond investor, one must thoroughly understand interest rates, the most basic feature of bonds. The value of a bond investment is very much dependent on today’s interest-rate environment and the potential future interest-rate moves.
Coupon Rate
Bonds as fixed income securities pay a set coupon rate, the rate used to calculate periodic interest payments on an issue. Two things affect the coupon rate: the issuer’s credit quality and the issue’s duration. In general, the better the credit quality and the shorter the duration, the lower the interest rate, and vice versa.
Yield
Unlike a coupon rate that stays constant, the actual yield(to maturity) on a bond fluctuates as the result of the changing supply and demand in the trading, any changes in current interest rates, as well as in the perception of future interest-rate moves. For an investor, the yield is the coupon payments relative to the purchase price of the bond, which changes over time for the same above-mentioned reasons. And a bond yield moves in opposite direction to the price.
As interest rates have come down so much in the last couple of years, bond prices have risen accordingly and that has been good for investors. But the question now is that if interest rates can’t drop much lower from today’s historical low, what would that bode for investors, especially when inflation expectation starts setting in? One has to think about possible dropping in bond values down the road.
Interest Rate Sensitivity: Short Term vs. Long Term
Investors care a lot about how much their bond holdings are sensitive to any interest-rate change, because moves in interest rates will be reflected in the changing of the bond prices, thus the value of their holdings. In a rate-tightening environment or a would-be one, longer-term bonds are more sensitive to rate increases. This is because such a potential bond holder would be locked up for too long at a lower coupon rate.
Now the investor would be unable to earn any ongoing higher rates, and thus would demand a higher yield by paying less when purchasing the bond, effectively driving down longer-term bond prices. Should there be a future tightening and should the tightening become progressive as the current economic recovery continues moving forward, there could very well be losses of value on longer-term bonds.
On the other hand, shorter-term bonds would be less influenced by upward moves in rates in terms of investors demanding a higher yield and thus there wouldn’t be much downward pressure on shorter-term bond prices. In fact, as investors contemplate whether interest rates will really go up, they would like to get into shorter-term bonds for the flexibility that shorter durations offer, potentially driving up shorter-term bond prices and delivering better returns for those shorter-term bond holders.
Investing in bonds is a lot about evaluating current interest rate environment and anticipating future interest rate moves.
Charles E. Johnson is an entrepreneur and the current owner of Articleportfolio.com. For more information on the bond market and investing in bonds, visit the Articleportfolio.com bonds page here: http://www.articleportfolio.com/buying-bonds.html.
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