A Misconception about the Value of Bonds

Do you own bonds and are hoping for interest rates to go up so that you can make more money? You’re not alone. Many people are confused about what makes bonds go up and down in value. Once you own a bond, you should be hoping for interest rates to go down, not up.

The return that you get from a bond is determined by prevailing interest rates. However, once you buy a bond, your interest rate is locked in not only for this year, but all future years until the bond matures. If rates go up, you don’t get to collect the higher rate next year. Instead, higher interest rates will make your bond then looks worse in comparison to new bonds and other investors won’t be willing to pay as much for your bond.

This is the basis for the inverse relationship between bond values and interest rates. Before you buy a bond, you’re hoping for higher rates, but after you’ve bought the bond, its value rises if interest rates go down, not up.

Comments

  1. AnonymousJanuary 19, 2012 at 4:06 PM

    parkedGiven a laddered portfolio it is advantageous for interest rates to go up as the bonds come due. If each bond in the ladder is held to maturity it makes no difference what happens to interest rates in the interim since the maturity value is already determined at the time of purchase.

    ReplyDelete
  2. Michael JamesJanuary 19, 2012 at 4:58 PM

    @Anonymous: I think increased interest rates are still a mixed blessing in this case. Higher interest rates are often correlated with higher inflation. For most bonds, the maturity value is fixed in terms of dollars, but not in terms of purchasing power. An increase in inflation would diminish the purchasing power of the matured bond. But, you're right that using a laddered approach takes some of the uncertainty out of a bond portfolio.

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