Techy Stuff – The Inverted Relationship Between Interest Rates and Bond Pricing

I am on record—in statements, in practice, and in my personal portfolio—of having a bias towards using Dimensional Fund Advisors mutual funds. I am also on record in stating that index funds—and Vanguard products in particular—are also a great tool to use in constructing your portfolio.

One of the most common questions that I have received over the past year is: “Should I be worried about investing in bonds given the current interest rate environment?”

The reason behind that question is that the movement in bond prices is INVERSELY related to the movement in interest rates. That means:

• Interest rates go up, bond prices go down.
• Interest rates go down, bond prices go up.

To understand why this is the case, let’s go a bit more into details with an example.

• When you buy a bond for $100 that pays say 5% interest over 10 years you are getting a commitment from the seller to pay you $5 every year for 10 years and then give you $100 back at the end of 10 years.
• Ignoring the time value of money, you would collect $150 in total over the entire time period
• Let’s say that tomorrow, interest rates climb to 6% versus the 5%
• Now when you buy a $100 bond you get $6 a year and a total of $160 over the ten-year time frame.
• So yesterday your $100 bond got you $150; today a $100 bond gets you $160. If you decide to sell the bond you bought yesterday, the buyer is NOT going to give you $100 for it—rather, he is likely going to give you $90 to make up for the loss of $1 in interest for the ten-year duration of the bond.

As we are in a very low interest rate environment at present, many are concerned about buying bonds and having the bond price fall quickly due to what they perceive as “guaranteed” interest rate increases on the horizon.

Three important points here:

• This same argument about “guaranteed” rises in interest rates has been put forth for the last several years, yet interest rates did NOT move. So much for that “guarantee”!
• The impact of the change in interest rates is dependent on the duration (i.e., essentially how many years remain until the bond matures) of the bond. Longer duration, bigger impact. Shorter duration, smaller impact.
• Most people do NOT buy individual bonds, but rather bond funds. AND these bond funds are constantly “cycling in” and “cycling out” bonds as they mature and as cash flow enters the fund.

What happens to a LONG-TERM INVESTOR is that the new bonds they purchase have a HIGHER rate of return, and it actually leads to higher returns long term.

Rather than go into great detail on this topic, I have attached a link to an article that Vanguard put out on this topic in 2010. A couple of points here:

• They emphasize the key point that bonds are a diversifier for portfolios that minimize volatility. This is a great/key point that I agree with!
• They conclude that there is no reason to panic/worry about the “bond bubble.” I agree.

The article was written in 2010, and the “bond bubble” did not “burst” over the following seven years as interest rates remain stable. Further, once the rates started to move in 2018, the “burst” was a non-factor. I would encourage everyone to think about this—and to think about how the media is a purveyor of “Financial Pornography.” (Side note: Take a look at this recent blog post to understand the harm you are doing to yourself— and possibly to your financial future—when you view the wrong things.)

Hopefully, you've learned a bit about bond prices and volatility in today’s finance topic review.

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Enjoy the read and remember, it’s NOT about the money. It’s about how the money supports your goals!

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