As Interest Rates Climb…

Interest Rates

Interest Rates (Photo credit: 401(K) 2013)

In Chapter 14 of Personal Finance, Turning Money Into Wealth, there is a section titled “Why Bonds Fluctuate in Value.” In that section we look at the relationship between bond prices and changes in interest rates.

There is an inverse relationship between interest rates and bond values in the secondary market: When interest rates rise, bond values drop, and when interest rates drop, bond values rise. As interest rates rise, investors demand a higher return on bonds. If a bond has a fixed coupon interest rate, the only way the bond can increase its return to investors is to drop in value and sell for less.

Where are interest rates right now? They’re pretty darn low. While they could creep down a bit more, there’s a lot of range for movement on the upside. This past spring there was a bit of a selloff in bonds as interest rates – what happened? As pointed out in the Wall Street Journal article “Get Ready for the Next Round of Bond Pain,” during this period, the 10-year Treasury bond rate rose by more than one percentage point to just above 2.7%. As a result of this jump in interest rates, long-maturity bond funds lost around 7.5% in value from early May through early July, and that’s even after taking into account interest income from the bonds being held by those funds.

Class Discussion:

1. In the article “Get Ready for the Next Round of Bond Pain,” there is a figure titled “A Glimpse of the Future” which shows how different bonds fund categories performed between May 2, 2013 and July 5, 2013. Be prepared to discuss why figure looks as it does. Be prepared to discuss this in class.

2. What strategy would you recommend for investors who are holding a lot of bonds? Be prepared to discuss this in class.

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