The Third Law of Investing
There is an inverse relationship between interest rates and bond prices.
“The investor’s chief problem — and even his worst enemy — is likely to be himself.”
— Benjamin Graham
When Benjamin Graham, the author of The Intelligent Investor, shared his thoughts about investors, he had no idea that his words would still ring true 90 years later. Yet, we often become our own worst enemies when we invest in securities we don’t fully understand, like bonds.
In order to understand bonds, it’s important to first remember that in their names all bonds tell us three things: the “par” or face value, the rate of interest that will be paid at a regular intervals and a maturity date. Bonds are issued by the U.S. Treasury, corporations, and municipalities. Here are their characteristics:
- Treasury bonds are issued by the U.S. government. Their maturities range from 20-30 years (for comparison’s sake, I am excluding Treasury bills and Treasury notes). They are available to purchase in increments of $100. Treasury bond interest is taxable at the federal level and is tax-exempt at the state level. Because they are backed by the “full faith and credit” of the United States government, Treasury bonds are considered “risk-free” investments.
- Corporate bonds have maturities that range from 1 to 30 years. They have a face value of $1,000. After a corporation issues the bonds, the bonds trade on a secondary market where their prices are dictated by supply and demand. Corporate bond interest is taxable at the state and federal levels.
- Municipal bonds have maturities of 1 to 10 or more years. Municipal bonds are issued in $5,000 increments. Interest earned from municipal bonds is tax exempt at the federal level and on the state level if the investor resides in the same state as the issuer of the municipal bond. If not, the interest is taxable at the state level.
For simplicity’s sake, I will use corporate bonds as an example.
While corporate bonds have long been considered safe investments, it is also possible for them to be speculative investments. In order to give investors an indication of their quality, independent rating agencies assign ratings to bonds. Two of the largest rating agencies are Standard & Poor’s and Moody’s. Standard & Poor’s assigns bond credit ratings, from highest quality to the lowest of AAA, AA, A, BBB, BB, B, CCC, CC, C, D. Moody’s assigns bond credit ratings that range from Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C, to WR (withdrawn) and NR (not rated).
While bond ratings tell investors the quality of a bond issue, the rating doesn’t give investors direction when it comes to how bond prices will trade in the secondary market. Because of that, it is common for bond buyers to misunderstand the most fundamental truth of how interest rate affect bond prices: there is an inverse relationship between interest rates and bond prices. Simply said, when interest rates go up, bond prices go down; conversely, when interest rates go down, bond prices go up.
In order to explain the relationship between interest rates and bond prices, here’s an example. Let’s say you own a high-quality AAA rated 20-year corporate bond that pays 5% interest annually. When you bought the bond at face value, $1,000, prevailing interest rates were such that bonds like the one you purchased were all trading at par. A year later, prevailing interest rates have declined to the point where new bonds of the same quality and a similar maturity pay investors 4%. When this happens, your AAA rated 5% bond looks more attractive to investors purchasing bonds in the secondary market and that will drive up the price of your bond.
Now, consider another scenario: a year after you purchase the same corporate bond, prevailing interest rates increase and new bonds of the same quality and similar maturity pay 6%. In this case, the price of your bond with the 5% coupon will drop in price because there will be less demand for your bond. Because investors will seek bonds with higher yields, the value of your bond will have to drop to a level where it’s current yield (annual interest earned ¸ by the bond’s current price) is competitive with the new bonds that are being issued. To make this much easier, we have a tool called duration.
Duration is a measure of the sensitivity of a bond or a mutual fund bond portfolio’s price to changes in interest rates. From a technical standpoint, duration measures how long it takes, in years, for the bond’s total cash flows to repay the bond’s price to the investor. Duration varies during the life of the bond and the duration of a bond fund will vary in duration as bonds are traded or mature.
Here’s how it works. Generally, for every year of duration, a bond or bond fund’s price will change approximately 1%. So, if your bond fund has a duration of 6 years, the price of your fund will increase by 6% for every 1% interest rates decline and drop by 6% for every 1% interest rates increase.
Now you understand bonds, their relationship to interest rates and how duration can help you demystify the bond buying experience.