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Taking advantage of the interest rate sensitivity of bonds

May 14, 2020

reading time: 5 Minuten

by Sidi Staub

interest rate sensitivity of bonds

When interest rates rise, bond prices fall – and vice versa. What investors should look out for.

A bond is a security issued by companies or governments, usually with a fixed interest rate and a fixed maturity date. Let’s use a fictitious corporate bond with an issue price of EUR 100, a maturity of eight years and a fixed interest rate of one percent as an example. When a bond is issued, the fixed interest rate is determined based on market interest rates at that time. The buyer of this bond therefore grants the company a kind of credit of EUR 100 and in return, receives an interest payment of EUR 1 for eight years. During the term of the bond, the buyer can sell the bond at any time at its current market price. If they keep the bond until maturity, they will be repaid the original amount of EUR 100. The bond’s annual yield corresponds to the fixed interest rate and is therefore one percent.

Rising market interest rates

Let’s assume that another investor wants to buy the bond from its owner after three years. This bond would then still have a remaining term of five years. Let’s further assume that interest rates in the financial markets have risen in the meantime and that the same company has recently issued a new bond with a maturity of five years. Both bonds will therefore fall due for repayment on the same date. However, due to the rise in market interest rates, the fixed interest rate of the new bond is two percent instead of one percent. The buyer now has a choice: they can either purchase the new bond with five annual interest payments of EUR 2 each or the old bond with five annual interest payments of EUR 1 each. In a simplified calculation, the total interest difference over the five years is five euros in favor of the new bond.

To compensate for this interest rate disadvantage from the buyer’s perspective, there is only one solution: the price of the old bond must fall by this interest rate difference, i.e. by about EUR 5 to EUR 95. The interest rate disadvantage of the old bond is then compensated for by the more favorable purchase price. This fictitious example shows: if interest rates rise, the market prices of existing bonds usually fall. Conversely, if interest rates fall, the prices of existing bonds rise.

Time to maturity is important

The extent of the respective price loss or gain also depends to a high degree on a bond’s remaining time to maturity. In this case, let’s look at two bonds, the first of which has a remaining term of five years and the second a remaining term of ten years. If interest rates are rising, the decline in price for the bond with the longer remaining time to maturity will be much greater. The reason for this is that in the case of the longer-maturity bond, the loss of interest will have an effect for five additional years. The same applies, of course, to falling interest rates: the longer the remaining term to maturity, the greater the price gain.

Conclusion

If investors expect interest rates to rise, they should look to buy short-term bonds or sell long-term bonds, thus reducing the average time to maturity of their bond portfolio. If, on the other hand, they expect interest rates to fall, they should buy bonds with a long maturity in order to benefit from possible price gains. If an investor is uncertain about future interest rate developments, they can also invest in an actively managed bond fund, where the risks are broadly diversified and the average time to maturity is managed by professional fund managers.

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