Rising Rates: What It Means for Bond Investors

Demystifying the mechanics of how bond prices are affected by interest rates.

February 15, 2017

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:

Rising Interest Rates (Price Decline)

 

5% bond coupon payment + -2% bond price chart = 3% investor total return

No Change In Interest Rates (No Price Change)

 

5% bond coupon payment + 0% bond price chart = 5% investor 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.

  • Bond Maturity
    All else equal, bonds with more time to maturity are more sensitive to interest rate changes than shorter maturity bonds.*

  • Coupon Payment
    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

Disclaimer

Consider a fund's investment objectives, risks, charges and expenses carefully before investing. The prospectus and the summary prospectus contain this and other information about the fund. Contact your financial professional for a prospectus and the summary prospectus. Read them carefully before investing.

An investment in our money market funds is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the funds seek to preserve the value of your clients investment at $1.00 per share, it is possible to lose money by investing in the funds.

Mutual fund investing involves risk. Some mutual funds have more risk than others. The investment return and principal value will fluctuate and investor's shares when sold may be worth more or less than the original cost. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Asset allocation and diversification do not assure a profit or protect against loss in declining markets. There is no guarantee a Fund's objectives will be achieved. The risks associated with each fund are explained more fully in each fund's respective prospectus. Consult with your attorney, accountant, and/or tax professional for advice concerning your particular situation.

This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation about managing or investing your retirement savings. Clients seeking information regarding their particular investment needs should contact a financial professional.

Investment products are distributed by Prudential Investment Management Services LLC, a Prudential Financial company, member SIPC. Separately Managed Accounts are offered through our affiliates. Jennison Associates and PGIM, Inc. (PGIM) are registered investment advisors and Prudential Financial companies. QMA is the primary business name of QMA LLC, a wholly owned subsidiary of PGIM. PGIM Fixed Income and PGIM Real Estate are units of PGIM. © 2019 Prudential Financial, Inc. and its related entities. Jennison Associates, Jennison, PGIM Real Estate, PGIM and the PGIM logo are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide.

Prudential Financial, Inc. of the United States is not affiliated with Prudential plc. which is headquartered in the United Kingdom.

Investment Products: Are not insured by the FDIC or any other federal government agency, may lose value, and are not a deposit of or guaranteed by any bank or any bank affiliate.