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Lovisa Alvin
Lovisa Alvin
Articles (40) 

Are Bonds as Safe as You Thought?

Treasury Bonds are considered to be risk-free

October 19, 2016

Treasury Bonds are thought of by some investors as a largely risk-free investment, but their ultimate value is actually affected significantly by a number of factors, including increases in interest rates. With a Federal Reserve interest rate increase looking increasingly likely, what would this mean for bond investors?

Changes in interest rates do, in fact, significantly affect the value of bonds. A rise in interest rates increases bond yield (due to higher discount rates) and this leads to a decrease in value. In particular, longer duration bonds are more affected by an interest rate rise than those of shorter duration because interest rate increases signal an anticipated rise in inflation, and inflation ultimately diminishes how much the purchasing power of the principal is worth when it eventually matures. As a result, this also reduces the price for which an investor can sell on a bond to somebody else before it matures, because not only do new bonds offer a better interest rate than those already issued, but the ultimate maturity value of existing bonds is diminished.

Duration (which is expressed in years and shouldn’t be confused with maturity, which is how long the bond lasts) is a crucial factor in determining the value of a bond because it is the weighted average time before all interest payments and the principal are received, and measures the value of a bond relative to interest rate changes.

Rising interest rates (because of actual and/or anticipated growth in inflation) mean that a bond with longer duration will fall in price because the ultimate value and purchasing power of the principal at the time of maturity will be lower. In addition, because new bonds issued after increases in interest rates offer investors better coupon rates than exisiting bonds, someone looking to sell on a bond before maturity can also, therefore, expect to receive a lower price as well. How much lower? In determining the degree to which interest rate moves affect the overall investment value of bonds, a principle that is generally applied is that rate changes (both up and down) should be multiplied by the bond’s duration. For example, if you hold a bond with a five-year duration and there is a 1% rise in interest rates, then you can expect the value of the bond to decrease in real terms by around 5%.

Prospective falls in bond prices triggered by interest rate rises do, however, provide an opportunity to make profits by short selling. Essentially, this means selling on bonds that you don’t own in anticipation of a price fall, and then buying them back at a lower price once a drop in value occurs – here you can learn how you can short sell assets with leverage. However, timing is of the essence, and any investors looking to short sell bonds needs to do so virtually as soon as any interest rate rise in announced; many large scale investors who have sought to increase yields by buying longer duration bonds may all head for the door at the same time, and so anyone contemplating short selling would need to act swiftly, as any fall in the bond price could be quick.

So, after considering the effect of interest rate rises on bond prices, what is the likelihood of it happening? Analysts and commentators all seem fairly united in their view that a Fed rate hike is set for some time soon, based on noise coming out of its September policy meeting. However, there would appear to be some division amongst members of the rate-setting committee as to if and when an interest rate increase is warranted, owing to what they believe is an absence of signs that inflationary pressures are mounting. However, most market analysts are nevertheless predicting a December rise.

This means it is likely the conditions suited to the short-selling of bonds will soon come about. As we have noted, an interest rate rise will have an immediate effect on bond prices, particularly those of longer duration, and so what is sometimes seen as a risk-free investment may soon become vulnerable to a significant drop in value. However, for anyone looking to profit form the short-selling of bonds, the climate would appear to be right, but it will pay to be on your toes, as it may well be that the bond price fall is rapid and dramatic when the Fed makes its announcement.

Disclosure: I do not own any shares or any stocks mentioned in this article.

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