by Doug Drabik, Fixed Income, Raymond James
There are many reasons to own bonds, but for many investors, one of the most important is principal preservation. Years of saving, investing, and market growth may help build wealth. Bonds can then play a different role, helping preserve that wealth while providing a predictable stream of income and cash flow.
That purpose can sometimes get lost when interest rates rise.
Bond prices and interest rates generally move in opposite directions. When market interest rates rise, the price of an existing bond typically falls. Why? Most of the bond’s characteristics are fixed. Its coupon payment does not increase just because newly issued bonds offer higher yields. Instead, its market price adjusts so that its yield becomes more competitive with prevailing market rates.
WHEN A LOSS APPEARS ON THE MONTHLY STATEMENT
That lower price can be unsettling when it appears on a monthly statement. But for an investor who purchased an individual bond with the intention of holding it to maturity, the market price tells only part of the story. Consider a bond purchased with a $100,000 face value that pays $4,000 of interest each year and matures in 10 years. If interest rates subsequently rise and the bond’s market value falls to $95,000, the statement may show a $5,000 unrealized loss. However, assuming the issuer continues to meet its obligations, the bond still pays the same $4,000 of annual interest and still returns its $100,000 face value at maturity. The market price has changed; the bond’s contractual cash flow has not.
WHY MANY INVESTORS BUY BONDS
This distinction is particularly important when comparing bonds with stocks. Stock investors generally need some combination of price appreciation and dividends to generate a positive return. For a buy-and-hold individual bond investor, interim price appreciation may not be the primary objective. An investor may instead be seeking predictable income, cash flow, and the return of principal at maturity.
That does not mean a bond's market price is irrelevant. It matters if the bond needs to be sold before maturity, and credit quality, call features, and other risks also matter. But if the original objective was to hold a high-quality bond to maturity, a temporary decline in its market value does not necessarily mean the investment has failed. Barring a default, a bond’s price eventually returns to par ($100) at its maturity, regardless of the holding period price volatility experienced.
In fact, rising interest rates can create an opportunity. Although higher rates reduce the market value of bonds already owned, they also allow investors to put new money to work at higher yields. Investors can potentially reinvest maturing principal and incoming cash flows at more attractive rates, increasing future income. Stock investors are often reminded not to panic when prices fall and to view lower prices as a potential opportunity. Bond investors should apply similar perspective to rising interest rates. Higher rates may make existing bonds look less attractive on a statement, but they can make new bonds more attractive to purchase. Today’s market opportunity allows investors to accomplish this with high credit quality issues, thus not needing to push credit risk standards outside of an investor’s comfort zone.
Remember why you bought the bonds in the first place. If the objective was principal preservation, predictable cash flow, income, and a known maturity value, an interim change in market price does not necessarily change that purpose. The statement reflects the market price at a point in time. The portfolio held is designed to deliver long-term objectives.
Copyright © Raymond James
