Interest Rate Risk Explained
Since the beginning of the year, the Bloomberg U.S. Aggregate Bond Index has declined in value by over nine percent which may come as a surprise if you didn’t realize bonds could lose money. Today, I’d like to explain how bonds can lose their value when interest rates rise.
As a quick refresher, bonds are simply loans from a lender to a borrower. Unlike your mortgage where you’re the borrower, owning bonds means you’re the lender typically to corporations or government entities who will eventually pay you back the original loan amount plus interest. Just like a mortgage, there’s an interest rate charged to the borrower along with a specific length the payments will be made. One key difference is usually the principal amount isn’t repaid until the end of the loan rather than along the way. Until maturity, you’re just collecting interest payments.
As interest rates fluctuate, the value of the bond you own changes inversely to interest rates because there’s an active market of buyers and sellers constantly repricing the value of your bonds based on a variety of factors. The most relevant factor for today’s article is current interest rates versus the original interest rate on your bond.
A simple example is the best way to understand this relationship. Imagine you own a bond paying one percent interest that you bought two years ago for $100. Fast forward to today and new bonds maturing at the same time as your original bond are earning 2.5 percent interest and selling for $100 each. If you wanted to sell your 1 percent bond, you would need to sell it for less than $100 to make it attractive to potential buyers. Perhaps you could sell it for $97 to make it competitive with a new bond. The decline in price represents the interest rate risk and would be a real loss if you sold the bond.
This risk around interest rates applies not only to individual bonds but also bond mutual funds which are comprised of a basket of individual bonds. The bond funds have more turnover of their underlying bonds so the proceeds from the matured bonds can be reinvested in new bonds at the higher rates which helps offset some of the price declines.
Besides understanding how rising interest rates affect the value of your bonds which increases the likelihood of sticking with your investment strategy, you could consider a couple of other strategies such as owning shorter term bonds which are less sensitive to interest rates. As rates increase, bank CDs or fixed annuities may become more attractive too. My colleague, Mike Haubrich wrote about Series I Savings Bonds last month which are also worth considering. No one likes to lose money on their investments but understanding why it happens may lessen the psychological impact.