An Inverse Relationship in Bonds [Post 35]

In the bond market, prices and yields share an inverse relationship. As interest rates climb, the values of existing (previously purchased) bonds drop.

Imagine this: a year ago, you bought a $10,000 1-year treasury at a 2% yield. At maturity a year later, your initial investment would return the $10,000 principal with around $200 in interest (2%).

However, say during that year, the market shifted, and 1-year treasuries were now offering a 5% yield. This rise in yields affects the value of your 2% treasury negatively.

Anyone holding a 2% treasury will prefer the 5% one, but unfortunately, it’s not so simple to just swap them and instantly be better off. Instead, the 2% bond’s value would decrease to a point where selling it for a 5% bond wouldn’t make financial sense in most cases.

A simple rule of thumb for bonds: for every 1% change in interest rates, a bond with a year left until maturity will change roughly by 1% in value in the opposite direction.1 This "inverse relationship" means that a quick shift from 2% to 5% treasury yields could reduce the original $10,000 investment to around $9,700 temporarily. (A 3% interest rate shift x 1 year x $10,000 = -$300 in current value)

Unless the bond issuer defaults, investors can expect to receive their principal back and quoted interest rate. However, the bond’s value may fluctuate in the intermediate term.

Understanding this inverse bond price-yield correlation is crucial for investors. It guides their strategies amidst changing yields, shaping investment decisions and market trends in the bond landscape. This also clarifies why, even with increasing interest rates, this environment can be deemed a "bear market" for bonds (down market).

No material on this website should be taken as tax, legal or investment advice. 

Image:

Genesis. (2018, August 26). Why Rising Interest Rates are Bad For Bonds? https://www.fromthegenesis.com/why-rising-interest-rates-are-bad-for-bonds/

Works Cited:

1.       BlackRock. (2004). Understanding Duration.

https://www.blackrock.com/fp/documents/understanding_duration.pdf