Conventional Wall Street wisdom tells you that when interest rates rise bond prices will fall. With interest rates at historic lows pundits tell us to avoid bonds as rates have no where to go but higher. This is true if you are trading in bonds but is the long-term bond investor really worse off due to rising rates? Let’s illustrate with a simple example. If you purchase a bond paying 4% interest for $100 but then interest rates rise to 6% for a comparable bond another investor will not pay you $100 for this bond. They may pay you $90 because they would only earn 4% interest rather than 6% interest.
If you are trading in bonds and not a long-term investor this is true, you will lose $10 of your principal. However, there are two situations where you will not lose money.
- You hold the bond to maturity
- If you sell a bond you reinvest the proceeds into another bond paying a higher interest rate
Holding the Bond to Maturity
If you hold a bond to maturity you will receive your entire principal back plus interest income along the way. Using the above example, you originally paid $100 for the bond. If you hold this bond to maturity you will receive your $100 back plus 4% interest each year. The distinction here is length of maturity. If the bond you purchase has 5 years left until it matures there is less risk your $100 of principal is eroded due to inflation. If you own a 30 year bond and interest rates rise holding to maturity would be devastating due to inflation. In a rising interest rate environment I would recommend keeping bond duration low. Bond duration is the remaining life of a bond until it matures.
Selling a Bond and Reinvesting Proceeds into another Bond
If you are using a long-term bond investing strategy I will illustrate that rising interest rates do not necessary cause you to lose money over the short to intermediate term.
Using the above example, you pay $100 for a bond paying 4% interest. This bond has 7 years until maturity. Let’s say 3 years into your bond ownership interest rates rise to 6%. Your $100 bond is now worth $90. If you sell this bond and do nothing you will lose $10 ($100-$90 = $10).
However, if you reinvest your $90 of proceeds into another 7 year bond paying 6% interest you will be no worse off. Let’s illustrate:
Hold 4% bond to maturity:
In Year 3, interest rates rise to 6%. You sell you 4% bond for $90 and reinvest in a new 6% bond:
|Loss on 4% Bond Sale||-10||0|
As you can see, holding the 4% bond to maturity will earn you $28 of income. Selling the 4% and reinvesting into a 6% bond will earn nearly as much income: $27.8 which includes a $10 principal loss on the sale of the 4% bond.
The same analysis will apply to an investment in a bond fund. If the fund manager sells a bond or is required to sell a bond in the case of an index fund, the fund manager will reinvest the proceeds into a bond paying a higher interest rate.