Fixed income securities such as bonds are instruments that typically pay interest, called the coupon, throughout their lifetimes and then return the face value at maturity. Even though they are less risky than stocks and commodities, bonds do have several risks, including the risk of default. Investors may feel there is no risk in owning a long-term U.S. Treasury bond, or T-Bond. However, while default risk is nil, there are other risks that investors need to consider.
Yield vs Price
A fixed-rate bond has a stated, unchanging coupon payment it disburses every period -- for instance, T-Bonds pay interest semi-annually. The total coupon payments for the year divided by the bond price is the annual yield. Coupons don’t change on fixed-rate bonds, but prices do, and thus so do yields. For an already issued bond to be sellable, its yield must compete with current interest rates. Thus, as rates and yields go up, prices must come down, and vice versa.
Interest Rate Risk
The scenario in which interest rates rise after a bond is issued leads to interest rate risk. Since prices will decline if interest rates rise, the holder of a fixed-rate bond may experience a capital loss if the bond is sold before its maturity date. The longer the period until maturity, the more the bond is subject to interest rate risk. At maturity, the bond will refund the face amount, so bonds near maturity have little interest rate risk. Bond duration is a mathematical equation that signifies how sensitive a bond is to interest rate risk -- bonds with relatively low durations are more resistant to interest rate risk.
What if interest rates go down instead? The price of a fixed-rate bond will rise and entice some holders to sell the bond for a profit. But others will hold onto the bond and will find that they cannot make as much interest income from reinvesting the periodic coupon payments they receive. This is reinvestment risk -- if interest rates go down, your interest on interest will decline. This lowers a bond’s yield to maturity, which is a function of the total income, including reinvested interest income, which will be provided by the bond.
Some bonds have variable coupons that float with current interest rates. These instruments tend to have stable prices because their coupons remain competitive within the changing interest rate environment. However, if interest rates go down, so will the bond’s coupon, cutting interest income. This is income risk. In addition, lower interest rates create reinvestment risk, whether the bond is fixed rate or floating rate. Floating rate bonds are suitable for investors who are more sensitive to interest rate risk than to income risk, such as investors who do not plan to hold a bond until maturity.
- Bond Markets, Analysis, and Strategies (8th Edition); Frank J. Fabozzi
- An Introduction to Bond Markets; Moorad Choudhry
- Bond Math: The Theory Behind the Formulas; Donald J. Smith
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