Bonds and Interest Rate Changes
With interest rates at such low levels, you might be wondering what could
happen to your bond portfolio if interest rates rise. Basically, interest rate
changes affect bond prices as follows:
- Interest rates and bond prices move in opposite directions. The price
of a bond will decrease in value when interest rates rise and increase in value
when interest rates fall. The price of an existing bond changes to provide the
same return as an equivalent, newly issued bond at prevailing interest rates.
If interest rates are higher than the rate on an existing bond, the existing bond
becomes less valuable because of the lower interest payments, causing the price
to decrease. Since you receive the full principal value at maturity, holding a
bond until maturity eliminates the impact of interest rate changes.
- Interest rate changes have a more dramatic effect on bonds with longer
maturities. Since long-term bonds have a longer stream of interest payments
that don't match current interest rates, their price must change more to compensate
for those interest rate changes.
- Bond price changes are less significant for bonds with higher coupon rates. Bonds with coupon interest rates near or above current interest rates will experience the least amount of price fluctuation. By understanding the effects of interest rate changes on bond prices, you can make more informed decisions regarding your bond portfolio.
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