When Interest Rates Rise

By Tom Kirk

True or false? When interest rates rise, bond values fall?

Answer: True

For example, say you bought a 10-year Treasury note for $1,000 that bears interest of 2 percent, but next month, the interest rate on the new 10-year Treasury note is 3 percent. Since investors can now buy the 10-year Treasury note and earn 3 percent on their money over 10 years, they are no longer interested in your 2 percent note. This is unless you are willing to sell it to them at a price less than $1,000, so when it matures in 10 years the appreciation they receive, plus the 2 percent interest, equals what they could have earned on a brand new 3 percent note. This means your $1,000, 10-year, 2 percent note is worth roughly $900 in this new 3 percent interest rate environment. This is a 10 percent loss on a Treasury – one of the “safest” investments that exist.

You may be thinking that if you just keep the 2 percent note until it matures you will get your $1,000 back and avoid the loss mentioned above. True, you will get your $1,000 back, but will likely still have suffered a loss. That’s because interest rates tend to rise during periods of increasing inflation. So your $1,000 plus 2 percent interest won’t buy in 10 years what it used to able to buy because the price of goods and services increased at say 3 percent over that period of time. In this case you are actually poorer in 10 years as a result.

This example is somewhat simplified and a little extreme to show the point. Interest rates on a 10-year Treasury note do not usually go from 2 to 3 percent in 30 days. But they will go up to some degree soon when the Federal Reserve begins its long-forewarned policy of raising interest rates as our economy improves.

This bond value depreciation during periods of increasing interest rates is magnified by the length of the bond. The reason the 2 percent note in the above example fell roughly 10 percent in value is because the new 3 percent notes pay to its investors 1 percent more per year for 10 years (10 percent in total) than the 2 percent note does. But, if the 2 percent note matured in only one year, its value would have only been negatively affected by roughly 1 percent.

This is why the bond portfolios our wealth services firm in Melbourne constructs for our clients consist of short-term (maturities of five years or less), investment grade bonds. As a result we are able to take advantage of the slightly higher yields of 5-year instruments, but also have very short-term bonds maturing that can be re-deployed into the current interest rate environment.

The bond portion of your portfolio can play an important role in your overall investment plan, providing a dampener to the volatility of your stock holdings and a reliable source of cash flow when you need it. But care must be taken when constructing your bond portfolio so it doesn’t let you down just when you need it most.

Please let our wealth services firm in Melbourne team know if we can help you use the markets to create the financial future you dream about.