A Good Bond Question

question markRecently, I had a client ask me about rising interest rates and how these can make bond values go down. This is a good question. Since we are currently in the midst of repositioning the bond fund portfolios for our clients due to this concern, I thought I would provide an example that should help illustrate how this works. Now on very simple basis let’s assume COMPANY A wants to raise capital to invest in their company’s widget project. COMPANY A announces they will pay 4% interest for 10 years to whoever will invest $100,000 in their company.

Individual INVESTOR B has $100,000 sitting down at the bank earning next to nothing and decides he is willing to lend the money to COMPANY A for 10 years to get a yearly 4% return.

COMPANY A and INVESTOR B meet and agree to terms and INVESTOR B lends COMPANY A the money.

COMPANY A starts paying INVESTOR B the 4% interest and everyone is happy, UNTIL a little way down the road, COMPANY A decides they now want to add onto the widget factory. In order to add on to the factory, COMPANY A needs to raise more capital to do so.

So now COMPANY A announces it is looking for a new $100,000 for 10 years, but this time they will pay 5% yearly interest. (The cost of things like gas, food, wages, Feds raised rates, etc. has gone up and changed over time since INVESTOR B first invested, so now COMPANY A has to offer more as an incentive to get additional investors).

This new announcement has caught the attention of INVESTOR C. She likes this idea and invests her $100,000 into COMPANY A for 5% and she is happy.

Well what about INVESTOR B? He is not happy that INVESTOR C is getting 5% while he is only getting 4%. INVESTOR B wants to get 5% too, so he decides to sell his bond in the OPEN MARKET.

The OPEN MARKET sees that INVESTOR C’s money is getting 5% and INVESTOR B’s money is only getting 4%, so the OPEN MARKET will buy the bond from INVESTOR B, but at a discount (i.e. The OPEN MARKET will give INVESTOR B for example $97,000 back, not the full $100,000 – this is the discount). Because INVESTOR B doesn't hold his money for the full 10 year period (maturity), and sells it at a discount, it is that discount for selling early when interest rates are higher that causes the bond to lose value. (Side note: if INVESTOR B holds his bond to maturity he will get his full investment back plus the 4%).

 

A loss in principal can be sudden if the Federal Reserve was to jack up rates all in one meeting or it could be slower if this rate of change is gradually. We believe this change in rising rates is beginning to occur, but we feel this transition will be slower in nature.

However, with that being said, we have begun to reposition our bond fund portfolios so we have pieces within the portfolio that change with the rise of rates, are positioned to react positively in a growing economy, and are shorter term in nature.

We believe that these factors will position accounts to provide yield and give a little flexibility to the defensive side of the portfolio.

One thing is for sure change is always happening and we are always watching and planning for our clients. Disclaimers:

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The purchase of certain securities may be required to effect some of the strategies. Investing involves risk including possible loss of principal.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.