Bonds have an inverse relationship with interest rates. When interest rates go up, bond prices go down and vice versa when interest rates move in the opposite direction. For longer dated maturities higher interest rates can be quite punishing. If you’re earning an annual 3% on a 10 year bond and interest rates go up to 6%, the bond corrects for this by declining in price so that the annual yield becomes 6%.
To understand how taxing higher interest rates are on bonds, it’s most illustrative looking at an example. I pulled down some data on a Treasury bond maturing on 5-15-21 from the Bond Center at Yahoo Finance this past Thursday. This 10-year bond with par value $100 and 8.125% coupon sells for $141.04 and yields 3.25%* per year. This 3.25% also implies the going rate if the Treasury were to issue any more 10 year bonds today.
Inflation for the 12 months ending February 2011 was 2.1% implying annual real rate of return of 1.15% for these bonds. If in a year’s time inflation were to spike to 6% (improbable but possible) the bond would fall from $141 to $106 or a loss of nearly 20% (after receiving the first year’s coupon payment).
However, the current bond market is uncharacteristic of years past. As Bill Gross mentioned in his monthly article the Fed was not previously a large buyer of Treasuries. Today the Fed is accounting for 70% of buying and may very likely be filling a void. Even as many investors today fear looming inflation, bond prices don’t seem to convey that and the Fed is likely responsible for this dichotomy.
The other 30% of the buying was being done by foreign investors. The Chinese had been a large purchaser of Treasuries as it was one of the few places it could park its dollars without selling them and driving the value of the dollar down. China has diversified into other currencies and has shown caution towards Treasuries. As Gross asked, who will be buying Treasuries in the future is a big question.
*I admit laziness and am neglecting 1.5 months from the 10+ years to maturity from my own calculation. The difference from the actual yield on Yahoo Finance is 8 basis points or .08%, but it should not have a material impact on the point I’m trying to make.