Zaks Investment Advisory Service

Bonds and Interest Rate Risk

We devoted our two previous programs to the credit risk of bonds. We explained how, with the exception of federal government obligations (i.e. Treasury bills, notes and bonds), all bonds are exposed to credit risk in one form or another, i.e. there is a possibility that the obligation to pay off the coupon and principal will not be met. These programs turned out being quite relevant considering the latest events hitting the financial markets: we witnessed a revaluation of risk on numerous bonds, the result being that prices on most corporate bonds, as well as stocks, fell. Meanwhile the prices on government bonds, whose credit-worthiness is never in doubt, went up.

By the way, a word about risky bonds. Investors usually only buy the highest-quality individual bonds. But this does not mean that lower quality and the so-called junk bonds have no buyers: these are purchased by large financial organizations that can afford to make riskier investments, as well as by investment funds. These funds purchase numerous types of bonds, including risky ones, diversifying the individual risk. So even if one of the bonds ends up in default (in case the issuing company goes bankrupt), this will have a relatively small effect on the entire fund. Investors buy shares of these bonds because the coupons paid on a junk bond are far higher than, for example, those on Treasury bonds. As usual, we witness the basic law of finances is at work: the bigger the risk, the bigger the potential reward.

But even Treasury bonds are exposed to a certain amount of risk: it is called the “interest rate risk,” or the risk of interest rate fluctuations. Some time ago, we devoted several programs to interest rates. Of course, you may read these programs on our site, www.zaksinvest.com. Interest rates are the price of money. If we want to borrow some money for, say, a year, than we have to pay for it. For example, we borrow $1,000 for one year. After a year, we return $1,100. So $100, or 10 percent, is the price we pay in order to borrow money for one year. Of course, this is a very simplified version, and we tried to examine this occurrence in more detail in our previous programs. At the moment, we are interested in the following: if the prevailing annual interest rate on the market is 10 percent, then $1,100 in one year will be worth the same as $1,000 are today: the present value of $1,100 is $1,000. But what will happen should interest rates go up? What will the present value of $1,100 be, paid in one year? It will be less than $1,000! Imagine that the market interest rate is 15 percent. If you borrow $957, then in one year, you will have to pay back $1,100. In other words, the present value of $1,100 at an interest rate of 15 percent is $957, while the present value of $1,100 at an interest rate of 10 percent is, as we saw, $1,000. We use interest rates to determine the present – or, as some people say, discounted – value of money. “Discounted” because the present value is always lower than the future one. As we learned from the previous example, the higher the interest rates, the higher the discount, and the lower the present value of future payments. This is a very simple but very important rule. Now let us get back to bonds. What are bonds? They are simply a flow of future payments, for which you are paying for now. Every half a year, you will be receiving a coupon, and once the bond matures, you will get back the principal. Each one of the coupons and the principal you get in the future has a present value. The price of a bond is simply the sum of all the discounted future coupons, and the principal. But we have just learned that the higher the interest rates, the higher the discount, i.e. the lower the bond’s present value. And, likewise, the opposite is true: the lower the interest rates, the higher the price of the bond.

This phenomenon may be observed on the market every single day. Every day, the interest rates change. And together with them, the prices on bonds change as well – only in the opposite direction. When one goes up, the other automatically goes down. This occurrence presents a problem for investors who buy bonds. When the interest rates go up, the value of their investment drops, and drops rather substantially. Imagine that interest rates rose from 10 to 11 percent. Under these conditions, the value of certain bonds with long-term maturity dates may have dropped by 20 percent, from $1,000 to $800.

The phenomena we just described is called “interest rate risk,” i.e. the risk that interest rates will go up and the value of bonds will decline. All bonds are exposed to this risk: federal, municipal and corporate. Unfortunately, there is not much that bondholders can do about it. Of course, if an investor has no immediate reason to sell, then he or she may simply wait for all of the coupons and the principal to be paid out, and not lose any money on the devalued bonds. Ob course not everyone can afford to keep bonds till maturity: sometimes investors need cash and are forced to sell their assets. Even if the bondholder keeps the bond and avoids capital losses, this does not solve all the issues. The problem is that high interest rates are often accompanied by high inflation, usually coming in direct consequence. The purchasing power of fixed bond payments earned during a period of high inflation goes down.

Can the investor do anything about this? Yes, although the way out of this situation may not be suitable for all. The fact of the matter is that during a period of high inflation, people should be investing in stocks rather than bonds. We will discuss why this is the case in our next program. For now, I would like to remind our listeners that on the Portfolios page of our site www.zaksinvest.com, we provide information about three model portfolios, and compare their performance to that of the market. Compare the returns of your investments to our model portfolios. If you do not know what the return of your portfolio is, contact us and we will calculate it for you. This was Sergey Zaks. Thank you for your attention and until next time.