A common adage in finance is that rising interest rates will cause the price of bonds to decline. This is not the case for all bonds, but the statement does have some truth. Let’s consider an investment in U.S. Treasury ‘separate trading of registered interest and principle securities’, a.k.a. Treasury STRIPS. Treasury STRIPS are fixed-income securities sold at a discount to their face value, or their value at maturity, and offer no interest payments in between the dates of purchase and maturity. The $100 face value 5 year STRIPS is a bond worth $100 when it matures in 5 years time, with no coupon payments made during the investment period, and is guaranteed by “the full faith and credit of the United States government.”
Given that the bond is worth $100 at maturity, what is the bond’s value today? The answer, in this case, is that it depends on the applicable prevailing interest rate. Assume that the applicable prevailing interest rate is 1.5% annualized. To determine the present value of the $100 cash inflow in 2018, the value is discounted at a rate 1.5% for each year of investment. The process of discounting requires solving the value in the previous timestep that appreciates at the stated rate to equal the value in the current timestep.
The result of discounting back the $100 cash inflow over a 5-year period provides a series of values equal to the time value of the bond.
Note that the time value, however, is not equivalent to the market value in between the time of purchase and maturity. Consider the purchase of the aforementioned bond instrument at the present time with the prevailing interest rate of 1.5%. The calculations above have established that the bond would be worth $92.83 in the present. The time value of the bond indicates that the bond should be worth $94.22 in year two of the investment. But this is only true if rates don’t change! If the prevailing interest rate moves from 1.5% to 3.0% then to calculate the value of the bond in year two we would discount the bond at the prevailing rate of 3.0% over the remaining time to maturity of 4 years.
This calculation dictates a loss in the investment of the first year of ~4.3%. Note that the value at maturity is still $100 (any value discounted back 0 years at any percent will be itself).
The fixed-income (or bond) portion of a portfolio, typically considered the more conservative side relative to the equity (or stock) portion, was the portion of the portfolio that required the most attention by many investment advisors this year. Fixed-income markets experienced significant volatility in the wake of announcements from the Federal Open Market Committee (FOMC) in May. Specifically, the FOMC made announcements that suggested a possible tapering of quantitative easing, which fixed-income markets interpreted as there no longer being a need for the federal funds rate to be near 0% (overnight federal funds rate on 12/16 was 0.09%). Shortly after the statement, the interest rate on the 10-year treasury went from 1.5% to 3.0%.
While no one can know with any certainty when the Federal Reserve will being tighten monetary policy, many analysts believe we have entered a rising rate environment. In such an environment, spaces within the fixed income asset class other than treasury bonds may offer more attractive features to investors. Interested readers are encouraged to contact our office for more information.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values may decline as interest rates rise and bonds are subject to availability and change in price.
Daniel J. Sandberg, Ph.D. and Alexander T. Radcliffe, Senior Research Analysts
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