If you’ve done your homework and are aware of the risks of owning bonds, then you might have heard the argument that you can eliminate interest rate risk by owning individual bonds and holding them to maturity. Let’s explore whether or not there is any truth to this line of reasoning.
What is Interest Rate Risk?
Interest rate risk is one of the primary risks that bond investors face. It’s also one of the most misunderstood. Put simply, interest rate risk is the risk that the value of existing bonds will decline due to rising market interest rates.
Many investors don’t realize that bonds are continuously traded on exchanges just like stocks. In fact, global bond markets are actually much larger than their stock market counterparts. Like stocks, bonds have prices that fluctuate based on a number of factors and are constantly changing to reflect new information. One of the most important factors that determines a bonds price is the level of prevailing, or market, interest rates.
What do I mean by market interest rates? The easiest way to think about this is the rate that new bonds are being issued at. Market interest rates are constantly changing and are impacted by such things as global events, perceptions about inflation, and the risk-appetite of global investors.
When market interest rates change, it affects the value of each and every existing bond. One of the worst scenarios for bond investors is that of rising interest rates. As market interest rates rise, it erodes the value of existing bonds.
Interest Rate Risk Example
Let’s walk through an example to see this in action, and determine whether or not owning individual bonds can eliminate interest rate risk.
At the time of this writing, a 1-Year U.S. Treasury Note currently yields 0.26%. If you were to purchase this bond for $1,000, you would receive $1,002.60 in one year’s time ($1,000 x 1.0026 = $1,002.60). For the sake of simplicity, we’ll assume no semi-annual interest payments and a complete return of interest and principal in one year’s time.
Now let’s explore a hypothetical situation in which the market interest rate on a 1-Year U.S. Treasury Note rises to 1% on the following day.
If an investor can now buy a one-year bond yielding 1%, what would entice them to purchase your bond, which only yields 0.26%, if you decided to sell? The answer is that you would have to discount the price of your bond to the point where the principal and interest the new investor will receive ($1,002.60) would be equivalent to a 1% yield, based on the price the new investor paid.
This means that the price, or value, of your existing bond, would fall to $992.67 ($992.67 x 1.01 = $1,002.60). That represents a decline of 0.73% on the price of your bond. Think about that for a moment. Your one-year bond only yielded 0.26%, and yet when market interest rates moved higher to 1%, your investment lost 0.73% of its value … that’s nearly three times the interest the bond pays over its lifetime.
Hopefully at this point you are beginning to see why interest rate risk can be detrimental to bond investors. To reiterate, any rise in market interest rates will erode the value of existing fixed-rate bonds.
What Can You Do About It?
There is a popular argument that you can eliminate interest rate risk by holding onto a bond until it matures. After all, just because the value of your existing bond declined when interest rates rose, doesn’t mean you have to sell it and take the loss, right? There is some truth to this statement, but as we’ll see, the outcome is quite similar regardless of whether you choose to hold the bond to maturity or not.
Continuing our example, let’s say you decide to hold your 0.26% bond to maturity. Assuming the issuer doesn’t default, when the bond matures in one year you will receive your $1,002.60. Great, you didn’t suffer a loss … or did you?
When interest rates rose to 1%, you could have purchased another one-year bond for $1,000 that earned a 1% yield. At the end of the one-year period, you would have received $1,010 ($1,000 x 1.01 = $1,010). By holding onto your existing, lower yielding bond, you missed out on the opportunity to earn an additional $7.40 ($1,010 – $1,002.60 = $7.40). That $7.40 difference equates to receiving 0.73% less upon maturity than you otherwise would have.
Now where did we see that 0.73% figure before? That’s the exact percentage the price of your lower-yielding bond declined when interest rates rose to 1%. If you think that’s a coincidence, think again. This relationship will hold no matter what the yields or maturities are of the bonds in question. It has to, otherwise there would be a glitch in the matrix.
So where does that leave us? Unfortunately, this example shows us that while you can avoid an immediate loss from rising interest rates by holding a bond to maturity, you are still losing value in the long run. Instead of taking the initial loss and then being able to reinvest at then-current interest rates, the loss is effectively spread out over the life of the bond in the form of missed income. Either way, when interest rates rise, the value of existing bonds declines. How you choose to conceptualize the loss of value, whether as an actual loss, or as a missed opportunity, is up to you.
One encouraging aspect of holding a bond to maturity is that your total return will in fact be positive, and (again, assuming no default) you’re going to receive your principal upon maturity. You may miss out on the opportunity to earn higher returns, but the return of your money is relatively certain. This is not the case with bonds fund. Bond funds differ greatly in their approach to owning bonds, and it is in your best interest to understand the difference between owning bond funds and individual bonds.