November 9, 2022
By Jessica Lanning, JD CFP®
The most commonly owned asset — a bond — is also the most misunderstood by and mysterious to consumers. They buy them because they’re told to (40% of your portfolio!) and are told they will be the “balance” to a down stock market. Until they’re not. Or until interest rates go up and then all of a sudden they’re “bad.” This article explains how bonds work and what’s so “bad” about them in a rising interest rate market.
Bonds Explained
Oversimplification makes learning easier, so let’s make it simple.
First, think of bonds like a product. Really, you can buy and sell them like any other product. If they weren’t highly regulated, you’d see them on eBay.com. You might have a highly desired product attracting a lot of potential buyers or one only attractive to you with no potential buyers.
People lose sight of them as a product because they live in the financial world, which scares a lot of people, and because people don’t think about loans as being something you can sell. You can.
Second, think of bonds like a loan. Here’s the basic structure:
- You lend money to an entity…
- You get paid periodically based on an interest rate…
- For a set time…
- At the end of which, you get your money back.
For the sake of this exercise, let’s go buy one.
Let’s say you buy a bond that:
- Lends $100 to the state of Maryland.
- You get paid annually on that $100 at 3%. The first year you get $3, the second year you get $3 and so forth.
- The loan — or the term — ends in five years. You will get $3 every year for five years, or $15 total ($3 times five equals 15).
- At the end of five years, you get your money ($100) back.
Let’s review.
- You lend $100 to the state of Maryland at 3% per year.
- You get $3/year for 5 years, which is $15 total. That’s your profit.
- At the end of 5 years, you get your $100 back.
Simple enough.
What Happens When Interest Rates Rise
Let’s say interest rates go up. There are now bonds available where you can lend $100 to the state of Maryland and get 7% per year for five years.
Let’s also say we’re at the end of year two, and you want or have to sell the above bond that you bought. Remember, it’s a product. You can sell it.
Now put yourself in the shoes of your potential buyer. Your buyer has a choice:
Choice 1: Buy a bond where the buyer lends $100 to the state of Maryland and gets 7% per year for five years, which is $35 ($7 times five year equals $35) and get the $100 back at the end of five years.
Or
Choice 2: Buy your bond for what you paid for it ($100), which only has a 3% interest rate with 3 years left of payments and get $100 back at the end of the three years.
If you were this buyer, which one would you choose? Most people are going to take the first choice. It’s more money in one’s pocket even in three years’ time ($21 from three years of payments at 7% compared to three years of $3 for a total of $9). It will also provide two more years of income (another $14 for a total of $35) before getting the $100 back.
How To Sell a Lower Interest Rate Bond
Given that you know this is the case, what do you do to entice this buyer to buy your bond over Choice 1? You’d do what any retailer would do to sell something fast: You’d lower the price.
How do you lower the price on a bond? Instead of selling it for $100, which is what you paid, you would sell it for less. Watch how this works.
- You sell your bond for $60.
- The buyer gets the next three years’ payments for a total of $9 (three years at 3% equals $9).
- At the end of the three years, the buyer gets $100.
- Note: That’s $40 more than what the buyer paid ($100 minus $60) plus the $9 of income over three years.
Whoa, wait. The buyer gets $100 at the end? Yes, that’s right. That’s what the product promises. Just because the buyer bought it at $60 doesn’t mean the buyer gets $60 back. The buyer bought the product, which pays $100 at the end of the term.
Look at the math. The buyer made $49 in three years ($9 of income and $40 in return) rather than $45 over five years in income alone on Choice 1. Pretty good deal for the buyer. (And it might have been a good deal for you, too, if you needed the cash.)
Important Implications of this Reality
With any luck, many of your worlds should be colliding and lots of things should start making sense. Let me draw your attention to a few highlights.
First, the longer the term the more interest rate risk. The chances that interest rates are going to change over 10 years is greater than over three years because there’s longer exposure to possible change. If you as a buyer worry about changes in interest rates, buy bonds that last for shorter periods.
When rates are rising, shorter term bonds are going to allow you to allow the bonds to come to term (we call this “holding to maturity”) and you get all your money back. Then, you can reinvest that money into bonds paying higher interest rates. Keep those until they mature and do it again.
The extension of this is called “laddered bonds.” This is where bonds are bought such that they mature at intervals so that new bonds can be bought as the old ones mature and you’re never having all of them mature at the same time.
Second, your bond has a value. Even if you don’t sell your bond, it has a price in the marketplace that changes with changes in the marketplace. The custodian of your bond (wherever you get your statements from) is going to assign it a price whether you want to sell it or not.
The shock here is that you might be happy receiving income off your bonds, but your accounts values are going down making you feel like you’ve “lost money.” You have not lost any money. Unless the borrower on your loan defaults, you are going to get your income and your money back at the end. If your intention is to hold it for the entire term, you don’t care about what its value is. Let it mature. Reinvest the money.
Lastly, everything comes with risk. There’s a chance that interest rates change, there’s a chance the borrower on your loan defaults or doesn’t pay up at the end, etc. While bonds are considered “safe” and “conservative,” not all of them are and not all of them are appropriate for everyone.
So Why Ever Sell a Bond?
Great logical next question. People sell bonds typically because they need the cash or there’s a better deal in the marketplace and it’s worth selling a bond to buy something else. It’s all about need and numbers.
In a rising interest rate market, it’s likely going to make sense to look at owning individual bonds for shorter periods of time. Conversely, in a lowering interest rate market, it’s going to make sense to buy bonds that will pay higher interest rates over longer periods. Predicting where interest rates are going to go is the trick.
Why Are Rising Interest Rates “Bad” for the Bond Market?
Again, to oversimplify….
With any luck, as you learned from this article, whether rising interest rates is “bad” completely depends on your perspective based on what you own, how long you intended to own it, and whether you are a buyer or a seller.
If you own a bond paying 3% for 10 years and a two-year bond is paying 4%, your bond probably doesn’t have a buyer, or if it does, it will be deeply discounted. Again, it doesn’t matter that the value on your bond is low if you intend to hold the bond for the full term.
But let’s say you own bonds in a fund (a bucket of bonds). Typically these funds are going to hold older bonds with lower interest rates. If your fellow fund owners start cashing out, that fund may be forced to sell bonds when it would have otherwise kept them to maturity. Because you do not control the individual bonds and when/if they get sold, your portfolio goes down.
If stocks are going down, too, this is going to feel particularly painful. Fortunately, it hasn’t happened that often. But it’s a good reason to actively manage individual bonds rather than own them through a fund.
If you want to explore what you own and the impact of the bonds in your portfolio, please reach out.
Lanning Financial Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.