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How Bonds React to Interest-Rate Changes

http://www.fool.com/investing/dividends-income/2010/06/22/how-bonds-react-to-interest-rate-changes.aspx

Chuck Saletta
June 22, 2010

If you buy a standard plain-vanilla fixed-rate bond, you can expect to receive its coupon interest payment on a regular basis, until that bond matures or the company declares bankruptcy. Assuming that the company stays out of bankruptcy court, you'll get the last coupon payment -- and regain the bond's face value -- on its maturity date.

That's the great part about bonds: As long as the company behind a bond remains solvent, you can predict what you're going to get by owning it. And because those cash flows are so predictable, you can get a pretty good feel for how those bonds will react to changes in interest rates.

How price and yield are related
The relationship between a bond's price and changes in interest rates is known as its modified duration. In essence, the modified duration will tell you how far a bond will fall (in percent terms) if interest rates rise by a percentage point. For example, if the modified duration of a bond is 10.5, then if rates rise from 4% to 5% overnight, the price of that bond can be expected to drop 10.5%.

While the math behind the formula is somewhat complicated, there are websites that can do the calculations for you, as can spreadsheets like Microsoft Excel. At its core, though, there are only a handful of factors that play into that value. The most critical ones are:

  • The bond's yield to maturity, which determines what your annual rate of return would be if you held that bond until it paid back its principal at the end of its life.
  • The bond's coupon yield, which is the interest rate you would get if you bought the bond at exactly its face value.
  • The bond's time to maturity, which measures how much life is left in the bond.

The higher the yield to maturity and the coupon yield, the lower the modified duration; and the shorter the time until maturity, the lower the modified duration.

Put it all together, and you get modified durations like these:

Company

S&P Debt
Rating

Bond
Maturity Date

Coupon Yield

Yield to Maturity

Modified Duration

Microsoft (Nasdaq: MSFT  )

AAA

6/1/2039

5.20%

4.63%

15.43

General Electric (NYSE: GE  ) Capital

AA+

11/21/2011

4.38%

0.83%

1.37

Wal-Mart (NYSE: WMT  )

AA

4/1/2040

5.63%

4.99%

14.88

Merck (NYSE: MRK  )

AA-

11/15/2011

5.13%

0.21%

1.35