Bonds are like a well-run train system – reliable, but not especially exciting – or so many investors think given the bond market's stunning 34-year running bull market. But if interest rates start to rise – as some experts believe they soon will – bond investments could become anything but boring.
On the face of it, bonds aren't that complicated. Simply put, they are the investor-funded debt of individual companies or various government entities. In exchange for the borrowed cash, these bond issuers make steady interest payments and repay the face value of the debt (often called "par") when it matures.
Investors who hold bonds to maturity are assured a steady source of income and the comfort of knowing exactly how much they will make off their investment. Buy a 10-year bond with a par value of $1,000 and a 2.5 percent annual coupon, and you'll get paid a total of $25 each year, leaving you with a cumulative $1,250 a decade later when you receive all interest payments and the principal. (That is, of course, unless the company or the government goes broke and can't make payments, or redeems the bond early.)
The interest rate that an issuer pays for a particular bond depends on a number of factors, including the issuer's risk profile and the duration of the bond.
Investors demand additional compensation for holding riskier bonds – those of corporations or government entities that are less likely than, say, the U.S. Treasury, to pay their debts.
But even for safe assets such as Treasury bonds, longer-term debt pays higher interest rates than short-term ones. Why? Simple. When investors hold a bond for 30 years, they're taking a much bigger chance that prevailing interest rates will erode the value of their investment. The rules of probability dictate that there is a far greater chance of some market-disrupting event happening over the next 30 years than in the next five years, and investors expect to be compensated for that risk.
Why interest rates matter to bond investors
Not all bondholders are alike. While some embrace the buy-and-hold approach and the steady source of income from interest payments, some want to be able to buy and sell bonds at will. This second type of investor needs to consider how much his or her bond will fetch on the open market when he or she is ready to sell – and much of that depends on what has happened to interest rates broadly since the bond was purchased.
Bond prices and interest rates move in opposite directions – when interest rates rise, bond prices fall, and vice versa. Think back to that 10-year bond with the 2.5 percent coupon. Let's say that six years later, interest rates have risen, and a newer bond is now offering a 4 percent coupon. An investor who bought the older bond and held it for three years would make just $75, when he or she could make $120 in three years with the newer bond.
Needless to say, whoever's selling the bond paying 2.5 percent should expect to sell it at a hefty discount to the bond paying 4 percent interest. Depending on what the investor paid for the bond in the first place–and whether he or she reinvested the interest payments well–losing money on the sale is a real possibility.
Generally speaking, interest rates for all kinds of debt, including mortgages, car loans, and yes, bonds of all kinds, take their cues from the short-term interest rates set by the U.S. Federal Reserve.
For the last six years, those short-term interest rates have held near zero. The central bank slashed rates dramatically as the financial crisis crested in 2008, hoping consumers would jump at the chance to take out a cheap loan for a mortgage or a car, or that companies would borrow money to build a new factory or buy another company. The Fed also hoped that at a time of panic in the financial markets, investors who were making a pittance with so-called "safe assets" such as Treasury notes would be more inclined to buy riskier assets just to earn a decent return.
To some degree, both of those things happened. Companies borrowed record amounts of cash to finance mergers and acquisitions and stock buyback plans, and investors have taken a shine to riskier assets, even as increased pressure on banks to deliver and hold greater collateral was also incenting them not to loan.
Interest rates on high-yield corporate bonds, or so-called "junk" bonds – the debt of companies with a high risk profile – fell to record lows in 2014 due to high investor demand. If you recall the adage we mentioned before, that means prices reached an all-time high.
What if the music stops?
But a bull market can't last forever, and it can be hard to predict what exactly will trigger a change in sentiment.
In the near term, however, some experts view the possibility of a rate hike by the Federal Reserve as one potential catalyst. Others, though, note that with weak growth in Europe, China, and Japan, the Federal Reserve may well decide to wait longer than that.
Guessing exactly when a rate hike will come is a popular hobby on Wall Street these days, but it's not just the managers of big bond portfolios who need to think about rising interest rates. Retail investors need to aware of the interplay between rates and bond values, too. When interest rates eventually rise, the value of their bonds will be in the crosshairs.