Interest rates

Jorgen Vik: Bond prices and interest rates seesaw | Lifestyles

Bond prices and interest rates are on opposite sides of a swing.

Many bond investors may have been surprised this year when they saw the value of their bonds fall. This year, according to Thomson Reuters, the Barclays Aggregate Bond Index, often used as a bond market benchmark, was down 13.2% as of June 14.

During this period, the interest rate on 10-year government bonds rose from 1.51% to 3.48%.

To understand this inverse sawtooth relationship between the price of a fixed rate bond and current market interest rates, think of bonds as contracts.

A borrower agrees to regularly pay a lender a certain amount of interest and principal at the end of the loan.

Today the government sells bonds – that is, it borrows money from bond investors – and today the interest rate on a 10-year loan is 2 .76%.

People also read…

So, for an investment of $100,000, you will receive $2,760 per year for 10 years, and at the end of the period, you will recover your initial investment of $100,000.

Next, let’s say that 10-year government bond interest rates rise to 4%. This means that a second investor at that time could buy a similar new bond by paying $4,000 per year.

If the first bond investor at this point wishes to sell their old bond, they will be offered less than their initial investment of $100,000.

After all, why would the second investor pay $100,000 for the first bond paying $2,760 per year when he can go to the open market and, for the same price, get a bond paying $4,000 per year?

Of course, she wouldn’t.

Instead, she might offer to pay less than $100,000 to make up the annual difference of $1,240.

Since current interest rates in this case have risen, the value of the old bond has fallen.

Rates up, bond prices down.

The dynamic is the same if rates go down. Then the old bond would increase in value because it pays more than is currently offered for the new bonds.

Rates down, bond prices up.

The original buyer of the bond may regret their purchase when they see the bond going down in value. But he will also know that if he holds the bond to maturity, he will see the price go back up to $100,000.

If you buy fixed interest bonds, remember that the price of the bond can go up and down until maturity due to fluctuations in market interest rates.

Jorgen Vik is a certified financial planner and partner of SKV Group LLC.