There are many reasons to own bonds, but for many investors, one of the most important is principal preservation. Years of saving, investing, and market growth may help build wealth. Bonds can then play a different role, helping preserve that wealth while providing a predictable stream of income and cash flow.
That purpose can sometimes get lost when interest rates rise.
Bond prices and interest rates generally move in opposite directions. When market interest rates rise, the price of an existing bond typically falls. Why? Most of the bond’s characteristics are fixed. Its coupon payment does not increase just because newly issued bonds offer higher yields. Instead, its market price adjusts so that its yield becomes more competitive with prevailing market rates.
See more: How Rising Bond Yields are Shaping the Market Outlook
WHEN A LOSS APPEARS ON THE MONTHLY STATEMENT
That lower price can be unsettling when it appears on a monthly statement. But for an investor who purchased an individual bond with the intention of holding it to maturity, the market price tells only part of the story. Consider a bond purchased with a $100,000 face value that pays $4,000 of interest each year and matures in 10 years. If interest rates subsequently rise and the bond’s market value falls to $95,000, the statement may show a $5,000 unrealized loss. However, assuming the issuer continues to meet its obligations, the bond still pays the same $4,000 of annual interest and still returns its $100,000 face value at maturity. The market price has changed; the bond’s contractual cash flow has not.
WHY MANY INVESTORS BUY BONDS
This distinction is particularly important when comparing bonds with stocks. Stock investors generally need some combination of price appreciation and dividends to generate a positive return. For a buy-and-hold individual bond investor, interim price appreciation may not be the primary objective. An investor may instead be seeking predictable income, cash flow, and the return of principal at maturity.
That does not mean a bond's market price is irrelevant. It matters if the bond needs to be sold before maturity, and credit quality, call features, and other risks also matter. But if the original objective was to hold a high-quality bond to maturity, a temporary decline in its market value does not necessarily mean the investment has failed. Barring a default, a bond’s price eventually returns to par ($100) at its maturity, regardless of the holding period price volatility experienced.
In fact, rising interest rates can create an opportunity. Although higher rates reduce the market value of bonds already owned, they also allow investors to put new money to work at higher yields. Investors can potentially reinvest maturing principal and incoming cash flows at more attractive rates, increasing future income. Stock investors are often reminded not to panic when prices fall and to view lower prices as a potential opportunity. Bond investors should apply similar perspective to rising interest rates. Higher rates may make existing bonds look less attractive on a statement, but they can make new bonds more attractive to purchase. Today’s market opportunity allows investors to accomplish this with high credit quality issues, thus not needing to push credit risk standards outside of an investor’s comfort zone.
Remember why you bought the bonds in the first place. If the objective was principal preservation, predictable cash flow, income, and a known maturity value, an interim change in market price does not necessarily change that purpose. The statement reflects the market price at a point in time. The portfolio held is designed to deliver long-term objectives.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
Investment products are: not deposits, not FDIC/NCUA insured, not insured by any government agency, not bank guaranteed, subject to risk and may lose value.
To learn more about the risks and rewards of investing in fixed income, access the Financial Industry Regulatory Authority’s website at finra.org/investors/learn-to-invest/types-investments/bonds and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) at emma.msrb.org.
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