The Inverse Relationship of Interest Rates and Bond Prices
What we’ve seen since the early 1980’s is a long trend of steadily decreasing interest rates. The chart below showcases this point.
Since declining interest rates mean higher bond prices this trend has driven the price of bonds up steadily over the last 40 years! At the same time, it is now making it increasingly difficult for bond traders to produce an attractive yield. Does this mean that the fixed income class no longer has a place in your portfolio? Not necessarily. The overall stability bonds can bring to a portfolio, and the consistent cash flow can still have its appeal. That said, we need to be cautious, and consider what may happen if and when interest rates begin to rise again. How might this impact the price of bonds?
The two tables below offer an oversimplified illustration of both scenarios. The first shows a drop in interest rates and how this increases the value of a bond. The second shows the reverse, and what happens when interest rates go up. For simplicity sake, we are ignoring the time value of money and assuming that the rate of inflation is zero. We are also not taking tax calculations into consideration, nor things like credit quality and credit ratings. The table is focused only on how interest rates can move the price of a bond.
Scenario 1: Interest Rates Decline on a 20 Year Bond from 2.0% to 0.5%:
| Coupon Rate | Face Value | Coupon Value | Bond Price | Price Increase |
|---|---|---|---|---|
| 2.0% | $100.00 | $40.00 | $ 140.00 | 0.00% |
| 1.5% | $100.00 | $30.00 | $ 130.00 | 7.14% |
| 1.0% | $100.00 | $20.00 | $ 120.00 | 14.3% |
| 0.5% | $100.00 | $10.00 | $ 110.00 | 21.4% |
In this scenario a drop from 2.0% to 0.5% interest rates resulted in bond prices going up over 21%!
Scenario 2: Interest Rates Rise on a 20 Year Bond from 0.5% to 2.0%
| Coupon Rate | Face Value | Coupon Value | Bond Value | Price Decrease |
|---|---|---|---|---|
| 0.5% | $ 100.00 | $ 10.00 | $ 110.00 | 0.00% |
| 1.0% | $ 100.00 | $ 20.00 | $ 120.00 | -9.1% |
| 1.5% | $ 100.00 | $ 30.00 | $ 130.00 | -18.2% |
| 2.0% | $ 100.00 | $ 40.00 | $ 140.00 | -27.3% |
Note that we are not saying that this is what will automatically happen if interest rates go up in the future. No one knows if or when rates might rise again, but this is a risk we need to be aware of and prepared to address.
Now consider the same example if the shareholder reinvested the dividend into more shares (as is typically the case witTo offset this risk, we at CH look to diversify our clients within the fixed income class. We add non-Canadian bonds, corporate bonds, and bonds issued in other currencies. Each of these factors can help to mitigate interest rate risk. We also look at alternative asset classes that we have discussed in previous articles. Finally, during our review meetings with clients we continue to focus on your specific tolerance for risk, and the corresponding rate of return that you expect from your investments. We then build a tailor-made investment portfolio to match your particular situation.
Best regards,
Brian Trafford, Chief Investment Officer
& Your CH Financial Team