The Relationship Between Bonds and Interest Rates

How will you play the US interest rate hike in December? The US Federal Reserve Bank has been teasing bond prices all year. In June, the central bank thought it might raise interest rates, so bond yields rose in anticipation. In September, bond yields rose again and then plummeted when the long promised interest rate rise was postponed once again. The rate hike is now scheduled for December. Savvy investors are buying while yields are low and hope to reap the rewards as interest rates rise. The US central bankers envision a continued, gradual increase in interest rates.

These investors understand the inverse relationship between interest rates and bond prices. If interest rates rise, bond prices will fall and yields will rise. In fact, yields are already rising on expectations of the rate hike.

Bond Yields

Bond prices fluctuate daily. When you purchase a bond, the price may be at par (100), or it may sell at a discount or a premium to the par value. If you buy a bond for less than par, your potential yield or profit will be higher. The yield is the return on your investment in the bond. If you pay a premium for a bond, your yield or profit will be lower. Like all shoppers, bond buyers do best when they buy at a discount.

This is the same as the value investing concept of buying stocks at a discount. If Apple releases an iPad with a major security flaw and sales plummet, it is a good opportunity to pick up Apple stock at a low price. You can then profit as the problem is fixed, iPad sales take off again and the stock price rises.

In the same way value investors look for temporary problems with companies to buy stock on the cheap, bond investors benefit from temporary slumps in economies. The US economy is slowly recovering from the recession. The yields on US bonds – which reflect the creditworthiness of a country – are lower than when economic growth is strong, but as economic growth picks up, the bond yields will increase.

Read: Is a high yield bonds portfolio the right tool for a low interest rate environment?

Buying a Bond at a Premium

Let’s say you have purchased a bond with a face value of $10,000 (par value). The bond pays a 10% annual coupon rate. To determine the yield, divide the coupon rate by the par value: 1,000/10,000 = 0.10. The yield is 10%. The US Federal Reserve then increases the interest rate in December causing the price of your bond to drop to $9,000. Your yield is now 1000/90,000 = 11 percent. The price is not likely to stay at $9,000. When interest rates are higher, more people want to place their money in higher yielding bonds. As demand rises for bonds, bond prices go up, and yields go down. In this way, your profit will rise and fall daily with the supply and demand for bonds.

If you want to know the yield to maturity calculation of the bond, then you need to include the time horizon of your investment and the frequency of coupon payments. Let’s say this bond will mature in 4 years and pays an annual coupon. If the face value of the bond is $10,000, the yield to maturity will be $4,000.

Buying a Bond at a Discount

Let’s consider another scenario. Following the Chinese stock market correction in August, the price of your Asian Market Bond Fund has risen from $10,000 to $11,000.  Investors fled Chinese stocks and put their money in bonds, forcing bond prices higher and yields lower. You expect Asian governments to lower interest rates in the new year to stimulate economic growth, which would further lower your bond yield. You bought the bond two years ago at a 10% yield. Your yield has now fallen to 9% (1,000/$11,000). You will have to sell your bond at a 1% discount to what you have paid for it, the par value.

Bond Prices and Stock Prices

Bond prices and yields are not only a good indicator of whether to buy bonds, but they also provide important information on stock prices. If bond prices are going up, demand is rising for bonds. When stock prices are falling or volatile, investors flee to the safety of bonds. The investment in bonds, in turn, will cause the Chinese yuan to rise, in this example.  Conversely, if bond prices are falling, stock prices are likely rising and investors have reallocated their investments to be weighted higher in stocks than bonds.

The Real Value of a Bond

The value of any investment depends on its opportunity cost. If you have a choice between investing in stocks and bonds for a period of 10 years, the opportunity cost of investing in bonds would be the difference in the 10-year return of the stocks and bonds. Let’s say the coupon rate on your bond is 2.5%.

Instead of buying bonds, if you were to place your $10,000 in a money market account, you could earn an interest rate of 4%. The money market account has no market risk so that 4% return in guaranteed. Bond prices, on the other hand, change as daily economic conditions change and have been more volatile than historical averages in 2015. Simplified for this example, you would need a return of at least above 4%, plus fees to rationalise choosing a bond investment over the money market account. The actual calculation would also factor in the market risk of a bond versus a money market account.

Understanding Interest Rate Policy

Bond investors closely follow the interest rate policies of central banks. Central bankers typically meet four times a year to decide on interest rate policy, and will hold at least one monthly meeting followed by the release of a press statement to update the public and markets on their sentiment towards the economy and a potential change in interest rates. For the US markets, the FOMC Watch provides an update on whether the sentiment is leaning towards an interest rate hike or lowering.

Even central bankers do not know for sure whether rates will be increased, lowered, or remain the same. The decision will be based on the state of the economy, which is influenced by numerous economic factors. Economic numbers to follow include retail sales, factory orders, productivity growth, employment, payrolls and non-farm payrolls, and inflation.

Before betting on bonds based on the expected direction of interest rates, closely follow interest rate policy for several months of the countries whose bonds you want to invest in. It is not uncommon for record breaking retail sales and productivity growth one month to be followed by steep declines in growth the next month. A low risk strategy is to invest in a diversified index of bonds.