When the fear of inflation sets in, the big question is: is it transient or permanent? For duty bearers, it is important to understand the implications of the answer.
If inflation is transitory, expectations of rising interest rates weaken. If inflation is the start of a persistent or worsening situation, expectations of rising interest rates will strengthen. This is because central banks have inflation targets – usually around 2% per year. And if the prices of goods and services rise too much, central banks can raise interest rates to curb activity in their respective economies.
Rising inflation can hurt bondholders in two ways: 1) erodes purchasing power whether bondholders receive fixed payments while the prices of goods and services soar, and 2) it reduces the value of bonds, provided that the expected interest rate hikes are integrated by the market. In this article, we’ll look at the latter effect – rising interest rates.
The relationship between interest rates and bonds
The market interest rate is a key factor in determining the coupon rate (i.e. the periodic payments of bonds). This is why changes in interest rates affect the value of bonds. But remember, this is an inverse relationship: higher interest rates cause bonds to fall in value, all other things being equal. Likewise, lower interest rates translate into higher bond values, all other things being equal.
We will present two examples of this inverse relationship between higher interest rates and lower bond value. Example 1): bond with a short maturity, and example 2): bond with a longer maturity.
Short Maturity Bond
For simplicity, we use a zero coupon bond with a 1 year maturity (zero coupon bonds do not distribute periodic coupons, rather they sell at a discount to the amount received at maturity).
We buy a zero coupon bond for $ 1000. In a year, we will receive $ 1,100, which is an interest rate of 10%.
The day after our bond purchase, the central bank raises the interest rate to fight inflation. Interest rates have gone up. Bad luck for us! We see that similar bonds in the market now offer $ 1120 in one year, corresponding to 11% interest. We have an (unrealized) loss because no rational investor will pay the same amount ($ 1,000) for our bond yielding 10% when they can buy a similar bond yielding 11%. But how much is our bond worth now that similar bonds are issued at 11% interest? The value of the bond must go down for our bond to also offer a yield of 11%. This means that our bond is worth $ 991 (1100 / 1.11 = 991), a decrease in value of $ 9 or -0.9%.
Bond with a longer maturity
This time we buy a bond with a maturity of 5 years, a 10% coupon interest and an annual coupon payment.
Again, luck is not on our side. The day after our bond purchase, the central bank raises the interest rate to cushion inflation. Rising interest rates mean that similar bonds offer an 11% coupon rate. How much is our bond worth now that similar 5-year bonds offer an 11% coupon rate? The value goes down so that our bond also pays 11%. But in this case, consider 5 years of payments. We would expect a heavier loss for the 5 year bond than for the 1 year bond due to the time value of money. Our assumptions are correct as the bond’s value decreases to $ 963 (the present value of 5 years of payments discounted to 11%), a reduction of $ 37 or -3.7%.
The examples in this article provide information about bond values ââand their inverse relationship to interest rates:
1. The value of the bond decreases when the interest rate increases, all other things being equal.
2. Changes in interest rates have a greater impact on the value of longer-dated bonds than on shorter-dated bonds.
3. The value of a bond is the present value of all of its future cash flows (essentially the same principle as for the value of stocks).
One strategy to protect fixed income portfolios against rising interest rates may be to reduce exposure to long-term bonds. We have seen that bonds with longer maturities are more negatively affected by rising interest rates than bonds with shorter maturities. Investors can also buy floating rate bonds or inflation-linked bonds to reduce the negative effects of inflation and rising interest rates.
This article does not constitute financial advice. It is always recommended that you speak with an advisor or financial professional before investing or making any changes to your portfolio or investment strategy.