Navigating the fixed income market can be daunting for the average investor. Understanding how changes in interest rates impact a portfolio is critical. Over a series of articles we will help demystify the mechanics of how bond prices are affected by interest rates, provide a baseline understanding of what factors influence U.S. interest rates, and introduce some solutions to help create a less interest rate sensitive portfolio.
Interest rates and bond prices are inversely related
Historically, bond prices and interest rates have moved in opposite directions. This happens because as interest rates rise, newly issued bonds carry a higher coupon than previously issued bonds, causing prices of older bonds to drop as they become relatively less attractive to investors. Conversely, older bonds become relatively more attractive than newer bonds issued after interest rates decline. This change in demand drives the bond price up or down.
The total return of a bond is comprised of yield (the bond’s coupon payment) plus market movements (the bond price increase or decrease). Here is an example of how the movement in interest rates affects a bond’s total return:
Declining Interest Rates (Price Increase)
5% bond coupon payment + 2% bond price chart = 7% investor total return
The above charts are hypothetical examples and are intended for illustrative purposes only. They do not depict a specific investment. All examples assume bonds purchased at par.
There are a number of characteristics that will impact exactly how sensitive a bond is to changes in interest rates. For example,
Magnitude of Rate Change
The greater the change in interest rates, the larger the impact to a bond’s price.
All else equal, bonds with more time to maturity are more sensitive to interest rate changes than shorter maturity bonds.*
Lower coupon bonds (again, all other characteristics equal) have greater interest rate risk than higher coupon bonds because they have a lower “yield cushion.”
* This statement assumes the bonds do not have call options.
While bond prices do tend to fall when rates rise, a steady stream of coupon payments can help to cushion some of the losses. This is why total return is such an important concept when it comes to fixed income investing. These coupons make it a possibility, though by no means a guarantee, to generate positive total return even when bond prices fall.
Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise.
Call options give the bond issuer the right to repay the bond before its maturity.
Coupon is the interest payment made by the bond issuer on a recurring basis.
Maturity is the length of time until a bond issuer repays the principal and the debt is considered repaid.
The views expressed herein are those of PGIM Fixed Income investment professionals at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice. Neither the information contained herein nor any opinion expressed shall be construed to constitute investment advice or an offer to sell or a solicitation to buy any securities mentioned herein. Neither Prudential Financial, its affiliates, nor their licensed sales professionals render tax or legal advice. Clients should consult with their attorney, accountant, and/or tax professional for advice concerning their particular situation. Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy.
0301927-00002-00 Ed. 07/2017