Basics of stocks and shares pdf ETFs Make the Market Go Up in Smoke? Subscribe to our e-mail newsletter to receive updates. Bonds have a reputation for being conservative, even boring. But no one ever accused them of being easy to understand.
I get a steady stream of emails and blog comments about bonds, and they reveal that many investors are very confused by how bond ETFs work, how they’re affected by changes in interest rates, whether investors can use alternatives to bonds, and even whether it’s OK to abandon them altogether. As a companion to the podcast, I’ve also created a short series of blog posts addressing the same questions. In this first installment, let’s dig into one of the most fundamental concepts for bond investors to understand: the inverse relationship between bond prices and interest rates: when one goes up, the other goes down. And why are we told to stay away from bonds because yields might rise?
You never hear people say you should avoid stocks because their dividends might get higher. I’m going to try to explain this important idea using a simplified example. 30 in interest each year for the next five years. Let’s also assume that just hours after Darryl buys his bond, interest rates rise sharply.
Enter Lisa, who is looking to buy a bond for her RRSP, so she approaches both Darryl and Larry about making a purchase. As you can guess, if both bonds had the same price, Lisa would obviously choose Larry’s bond because it pays more interest. But although Darryl’s bond pays less than the prevailing rate, it’s not worthless. This is where we turn to the elegant mathematics of bond pricing.
The value of Darryl’s bond will fall just enough so that its total return will be the same as Larry’s. That is the price at which Darryl’s bond would deliver the same return as Larry’s over the full five years to maturity. 50 less than Larry’s bond paid. And assuming she is able to reinvest all the interest payments at the prevailing rate, her total return will also be 4. Even if you struggle a bit with the math, I hope you now understand the main idea: that is, why bond prices fall when interest rates rise. To attract investors like Lisa, Darryl would have to lower the price of his bond just enough to make it equivalent to Larry’s bond with its higher coupon. 955, investors like Lisa now have no reason to prefer Larry’s bond over Darryl’s .
Of course, the opposite is also true: if interest rates fall, older bonds with higher coupons become more valuable. If you’re a Couch Potato investor you’re probably not buying individual bonds: you’re more likely to buy index funds or ETFs that hold hundreds of bonds. But the principle is still the same: when interest rates rise, the value of all these underlying bonds will fall in value, so the price of your fund will decline to reflect that. Now here’s the silver lining in all of this.
Because the coupons on existing bonds don’t change when rates move, the interest payments you receive every month likely won’t get any lower. Here’s where it pays to think like dividend investors, who seem much more willing to tolerate a decline in the price of their stocks so long as their income stays the same. Indeed, if rates rise gradually, the interest payments on a bond fund will increase as older bonds mature and newer ones are purchased with higher coupons. That means every new dollar you put into your bond fund will have a higher expected return than in the past, because you’re paying less for every dollar of interest. Bond Basics 3: Should You Wait for Higher Yields? This is true for fixed rate bonds only.