Wh at i f I n t e r e s t R at e s R i s e ?
A Special Commentary Series
bond basics
During the next few months, Janney experts will comment
on interest rate risk related to equities, fixed income, the
economy, and the markets. Since U.S. interest rates have been
declining for a long time, investors may not be aware of how
rising interest rates may affect their investments. The following
information describes the relationship between interest rates
and bond prices, and duration as a measure of bond risk.
Interest rates and bond prices:
an inverse relationship
Most investors understand that bonds are sensitive to interest
rates, and that this relationship is inverse, but they don’t often
know why or how. The answer is in the math. New bonds are
issued with a set (or par) value, typically $1,000—the amount
you’ll get back if you hold the bond until it matures. Bonds
also have a set coupon (interest rate)—the amount the issuer
will pay you in periodic interest installments for the life of the
bond in return for the use of your money.
That’s what happens when you own a bond for its entire
lifespan—however, if you choose to sell your bond before it
matures, or you own bonds as part of mutual funds and other
pooled financial instruments, you will be subject to interest rate
risk. Interest rate risk comes into play when bonds are bought
and sold on the open market. At that point, they compete with
new bonds, which may have higher or lower interest rates,
depending on the prevailing interest rate environment.
So that existing bonds can compete with new bonds, their
price automatically adjusts higher (premium) or lower
(discount), depending on current interest rates. In other
words, when interest rates rise, the price of the bond is
lowered to pay the bond purchaser the equivalent of the
higher interest rate (yield).
For example:
If you buy a new issue bond with a 5% coupon at $1,000 par
value, the “current yield” is 5% ($50/$1,000 = 5%). Let’s
say interest rates rise, pushing the current yield to 6.25%. In
order for that bond to be competitively priced in the market
place, the price of the bond would fall to $800 ($50/800 =
6.25%). The opposite would occur if interest rates push the
current yield down to 4.16%. The price of the bond would
rise to $1,200 ($50/$1,200 = 4.16%). Remember the bond’s
coupon always remains at 5% or $50. It is the price of the
bond that fluctuates up or down to increase or decrease the
yield when a bond is bought or sold prior to maturity.
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Duration: a measure of interest
rate risk for bonds
Duration allows for the direct comparison of bonds with
different maturities and coupon rates. The higher the duration,
the higher the risk of price changes as interest rates change.
That’s because as a bond’s time to maturity increases, duration
also increases, and the bond’s price becomes more sensitive to
interest rate changes. For example, the price of a bond with
an effective duration of “2.0” will rise (or fall) 2% for every 1%
decrease (or increase) in yield.
Chart A provides a simple comparison of Treasury securities
with maturities from 1 to 30 years. It shows the hypothetical
affect of an increase in interest rates on each bond’s price.
The chart clearly demonstrates that when interest rates rise,
principal loss is greater in bonds with longer maturities.
Your Janney Financial Advisor can analyze the interest
rate sensitivity of your bond portfolio and provide
recommendations to help manage risk.
Chart A: Bond Maturity/Price Change
Price
$1,000
1%
2%
3%
$800
$600
$400
1-Year Bond
5-Year Bond
10-Year Bond
20-Year Bond
30-Year Bond
MATURITY
(Source: Janney Fixed Income)
Price changes are estimates based on an instant “shock” in interest rates a/o Feb 20, 2013.
Securities used to estimate market value are “on the run” Treasuries, including 1-Year
T-bill, 5-Year and 10-Year Treasury Notes, and 20-Year and 30-Year Treasury Bonds.
For more information, contact your Janney Financial Advisor.
This report is for informational purposes only and in no event should it be construed as
a solicitation or offer to purchase or sell a security. The information presented herein is
taken from sources believed to be reliable, but not guaranteed by Janney as to accuracy
or completeness. Any issue named or rates mentioned are used for illustrative purposes
only, and may not represent the specific features or securities available at a given
time. For investment advice specific to your individual situation, or for additional
information on this or other topics, please contact your Janney Financial Consultant
and/or your tax or legal advisor.