The Interest-ing Thing About Bonds

Bonds are all about interest rates, and a rising interest rate isn't always a good thing for bonds. Here's why.

It's All About Interest, Which Isn't Always Good for Prices

When shopping for a loan, you look for the lowest interest rate you can find. But when you're investing in loans, the higher interest, the better. It's where you make money.

Because you can buy and sell bonds, they also have a price, and that price can go up and down, just like a stock price. As with stocks, if you sell high, you make money; if you sell low, you lose money.

Why would the price of a bond change if bond investors are mostly focused on interest? Interest rates, that's why. 

The amount of interest a bond pays depends on lots of stuff going on in the economy; notably, inflation. As the economy changes, interest rates, as measured by the federal funds rate, can change. And that's when bonds get a little more exciting.

What Happens When Interest Rates Go Up?

When interest rates go up, so does the amount of interest a borrower has to pay to get a loan. Since bonds work like loans, that means more money for you, the loaner, but only if you're buying a new bond.

In the chart below, the federal funds rate, and, thus, interest rates, ­spiked in the 1980s. Rates peaked above 19% in 1981, and rarely dropped below 10% in the first half of the decade. That was good news for people buying new bonds, and getting paid back at much higher interest rates. 

Your old bond's interest rate isn't going to change. It's locked in. Remember, bonds are predictable: they tell you up front how much you're going to get paid and for how long the organization issuing the bond will make payments. You could try to unload your bond and get a new one, but who's going to pay the original sticker price for your old bond with all those shiny new bonds paying more interest? You'd have to cut the price to get buyers interested. That's called a discount.

And that's why rising interest rates cause existing bond prices to fall.

What Happens When Interest Rates Go Down?

Of course interest rates move down, too. When that happens, you get the opposite scenario: new borrowers don't have to pay as much interest, so investors who buy new bonds won't make as much money as they would with older bonds that were issued back when rates were higher. That makes your old bonds with a higher interest rate look pretty nice by comparison.

Given the opportunity, investors are willing to pay more for your old bonds with higher rates than they would for new bonds with lower rates. That's known as a premium. And that premium makes the price of old bonds rise when rates fall.

So there you have it: when rates rise, it takes a bite out of your bond earnings. When rates fall, you make a little more money.

What Should I Do When Interest Rates Change?

You don't always have to stand by helplessly when interest rate changes affect the prices of your bonds

There are ways to minimize the effects of price changes in a portfolio.

When interest rates rise, you could buy some new bonds to try to smooth out price changes over time. You could also use a bond fund (from which a pro may make you some extra money by making favorable bond trades). You can even build what's called a bond ladder, which replaces old bonds with new ones on a regular basis to smooth out the effects of rate changes.

Although, before you do any of that, consider doing nothing. If you bought your bonds to balance out your stocks, sweating price changes probably won't be worth the extra effort.