The Relationship Between Bonds and Interest Rates
If rates rise 1%, the price of a 10-year bond falls about 10%. Bonds are a safe asset, but interest-rate risk clearly exists.
The Inverse Relationship Between Bonds and Rates
Bond prices and market interest rates move in opposite directions. Understanding this inverse relationship is the heart of bond investing.
Example: you bought a bond paying 3% annual interest for about $740. Afterward, market rates rose to 5%. Now newly issued bonds pay 5%. To sell your 3% bond, you must lower the price. The price falls so that even receiving 3% interest, the buyer's final yield becomes 5%.
Conclusion: rising rates -> existing bond prices fall. Falling rates -> existing bond prices rise.
Duration: A Measure of Rate Sensitivity
Duration is a metric showing a bond's sensitivity to interest rates. Roughly, it indicates "by what percent the bond price changes when rates change by 1%."
2-year bond: duration about 1.9 -> price falls about 1.9% on a 1% rate rise 10-year bond: duration about 8.5 -> price falls about 8.5% on a 1% rate rise 30-year bond: duration about 20 -> price falls about 20% on a 1% rate rise
The longer the maturity, the more sensitive it is to rate changes. This is why long-term government bond ETFs (TLT) fell more than 30% during the U.S. rate surge in 2022.
For a coupon bond, duration is a weighted average of the coupon payment dates and is shorter than the maturity.
Why Put Bonds in a Portfolio
The role of bonds is not to maximize returns.
1. A buffer when stocks fall: in a recession, rates tend to fall, so bond prices rise. When stocks crash and bonds rise, the overall portfolio's decline is reduced.
2. Stable cash flow: interest income (coupons) comes in regularly.
3. A source for rebalancing: when stocks fall, you can sell the risen bonds to fund buying stocks.
However, in periods of surging inflation and rates like 2022, stocks and bonds fall together. Bonds do not always move opposite to stocks.
Preguntas frecuentes
Q. Is it good to invest in bonds now, while rates are high?
Buying bonds when rates are high lets you receive high interest, and if rates later fall, bond prices rise, so you can also expect capital gains. Conversely, if rates rise further, bond prices can fall more. Predicting the direction of rates is difficult. This service does not provide a bond calculation feature, and we recommend consulting a professional for bond investing.
Q. What is the difference between government bonds and corporate bonds?
Government bonds are issued by the government and have almost no credit risk (low probability of bankruptcy). Corporate bonds are issued by companies and their risk varies by the company's creditworthiness. Corporate bonds with higher credit risk offer higher interest (a spread). During an economic crisis, a flight to safe assets tends to increase demand for government bonds while corporate bonds fall.
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