Bond investors could be in for a wild ride if interest rates rise

In 2013, I wrote an article for the Bradenton Herald titled “Bond Teeter Totter.” It described that a teeter totter can be an estimator of the value of a bond when interest rates fluctuate.

A bond usually has an issuer, such as a corporation, school board, bank or someone wanting to borrow money.

The basic idea is the issuer sets a rate of interest and a maturity date. You buy bonds usually in multiples of $1,000, the issuer pays interest of about 5 percent annually, and you get your $1,000 back at some point in the future, from 1 day to 30-plus years. Banks do something similar with a certificate of deposit.

The “bond” is the issuer’s promise that they will pay interest on time and return the $1,000 at maturity.

Credit rating agencies Moody’s, S&P and Fitch rate bonds using letters, though some are not rated for various reasons.

A bond rated AAA, AA, A or BBB is called investment quality or grade. If the bond is lower quality and rated BB, B, CCC, CC, C or D (default), the interest rate is usually higher than investment quality. The investor is taking a greater risk that this “junk” bond might not pay its interest or principal since they have a higher default risk then investment-grade bonds..

What happens to the bond’s price before maturity? It will fluctuate similar to a teeter totter. Think of one side as interest rates and the other as the principal value of the investment. When one side goes up, the other goes down.

This concept often applies to taxable corporate bonds, tax-exempt municipal bonds, preferred stocks and other fixed-income securities because they are interest-rate sensitive.

UP AND DOWN

For the past 35 years or so, long-term taxable bond interest rates declined from the area of 12-plus percent to about 4 percent today on fixed-income bonds maturing in 20-30 years. Like the teeter totter, that means when interest rates went down, bond prices went up. For most, that was good.

But now there is the likelihood that interest rates will be raised by the Federal Reserve on Wednesday, which means bond prices would go down. For most, that will be bad.

Historically, interest rates have risen when the economy is strengthening and corporate earnings and balance sheets are improving. This generally bodes well for stock equities.

It’s true that if you can hold to maturity, perhaps 30 years, you’ll get the $1,000 back. But you won’t get back the same $1,000 because of inflation.

What if you need the money before maturity? The value could be more or less than what you paid.

In 2013, the Financial Industry Regulatory Authority (FINRA) issued an investor alert titled “Duration – What an Interest Rate Hike Could Do to Your Bond Portfolio.”

As an example, FINRA wrote that a BBB investment grade corporate bond with a duration of 14.5 years, similar to maturity, might experience a loss in principal of 26 percent if interest rates were to rise by two percent from today’s low levels.

If your annual bond interest is 5 percent and the bond’s value declines by 5 percent each year, your total return is about 0 percent. So you might wonder about some ways of preserving principal.

Two ways are to shorten the maturity and improve the quality. Your income may decline, but that’s the price you pay to preserve your principal.

WINNERS AND LOSERS

Some elderly people might not care about preserving principal – they enjoy living off the income and hope they don’t need the principal, which may be more of a concern to their heirs.

Some win, some lose.

At the bank, short-term CD’s and savings accounts may see rising interest rates as beneficial. Bond holders may also see rising rates and might not enjoy them as much because they bought at a lower interest rate and are now losing principal.

For 35-plus years, interest rates generally went down and bond prices up. It looks like the reverse is about to happen, but these are expectations and not certainties.

So buckle up for an expected interest-rate ride.

This story was originally published December 12, 2016 at 11:56 AM with the headline "Bond investors could be in for a wild ride if interest rates rise."