Bond prices don't always depend on interest rates

June 25, 2011

Understand whether bonds lose value when interest rates rise.q

Q: Do all bonds lose value when interest rates rise?

A: Generally, the answer is yes, because the price of a bond and its yield (interest rate) are inversely related. Here's why: Suppose you purchased a 10-year bond issued by the U. S. Treasury Department that pays an interest rate of 3%. A year from now, interest rates rise, and the treasury department issues new 10-year bonds paying an interest rate of 5%. You may want to sell your bond and purchase the new 5% bond. But to find a buyer for your 3% bonds, you will have to lower the price, because they pay a lower yield.

This example highlights interest rate risk for treasury bonds. Treasury bonds have almost no credit risk because they are guaranteed by the full faith and credit of the U.S. government, but they are very sensitive to changes in interest rates.

Whereas treasury bonds will fall in response to rising interest rates, the corporation that issued your bond may see its finances improve and therefore become less likely to default on its bonds, thereby improving its credit rating. With an improved credit rating, the interest rate that investors demand will decline, resulting in an increase in bond prices.

The bottom line is, as an investor, you need to understand the nature of the risk governing the bonds in your portfolio to judge their value as an investment.

Send your money management questions to medec@advanstar.com Answer provided by Bryan Koslow, MBA, a financial adviser with Hudson Wealth Management LLC in Red Bank, New Jersey. Hudson Wealth Management LLC is not affiliated with Multi-Financial Securities Corp. Securities and Advisory Services offered through Multi-Financial Securities Corp., member FINRA/SIPC.