If the interest rates rise, won't the bond prices go down?

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kamred
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If the interest rates rise, won't the bond prices go down?

Post by kamred » Sun Oct 23, 2016 2:26 pm

Bogleheads,

I am curious to understand what would happen to bond prices [eg: VBMFX] when the interest rates go up. Won't the bond prices go down?

I ask because I am considering introducing bonds into my asset allocation but worry that the potential increase in interest rates will drive the bond prices down.

Please share your thoughts.

Thanks,
KamRed

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LAlearning
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Re: If the interest rates rise, won't the bond prices go down?

Post by LAlearning » Sun Oct 23, 2016 2:27 pm

yes. it will be small compared to the stocks you hold. and dont forget then they earn more.
I know nothing!

dbr
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Re: If the interest rates rise, won't the bond prices go down?

Post by dbr » Sun Oct 23, 2016 2:32 pm

LAlearning wrote:yes. it will be small compared to the stocks you hold. and dont forget then they earn more.


Correct. The details can be found in myriad posts on this forum. For a discussion look up the term "duration" https://www.bogleheads.org/wiki/Bonds:_ ... s#Duration

In general it will benefit investors for interest rates to rise as a major problem today is the low yields in bonds.

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Re: If the interest rates rise, won't the bond prices go down?

Post by larryswedroe » Sun Oct 23, 2016 2:34 pm

sorry but the answer isn't YES, it is it depends. Bond prices will fall only if rate RISE MORE than already expected as represented in the yield curve

One way to think about it based on the expectations theory of rates, with the 10 year say at 1.75% and 30 day rate at .25%, the market expects the 30 day rate to average 1.75% over the full 10 years, so clearly its expecting rates to rise (this ignores any idea of a risk premium for unexpected inflation or unexpected real demand rising). So for example if you assume rates rise at even pace over the next 10 years we will end up with the 30 day rate at about 3.5%.

Now here's another thought. If FED tightens more than expected the market could send longer bond yields lower as it might mean weaker economy and lower inflation than previously expected. Depends on why the market thinks FED tightened and did they tighten more than expected.

Remember that the key to understanding how any news impacts market is not the news itself but whether it was better or worse than already expected--something most investors unfortunately fail to understand causing them to be overenthusiastic when news is good and too bearish when news is bad (depends on whether it was worse than expected, not if bad)

Larry

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Re: If the interest rates rise, won't the bond prices go down?

Post by dbr » Sun Oct 23, 2016 2:39 pm

Larry, thanks for that illuminating point.

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Re: If the interest rates rise, won't the bond prices go down?

Post by Quark » Sun Oct 23, 2016 3:08 pm

If the interest rate on a bond rises, the market value of the bond will decrease (whatever expectations might have been), but after a while, the higher yield will increase value more than enough to make up for the initial loss (assuming you're reinvesting). That time period is equal to the duration of the bond (assuming no other changes).

If the Fed raises, then the market will move depending on how the increase (and accompanying Fed statement, etc.) compares with the market's expectations, as Larry writes.

kamred
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Re: If the interest rates rise, won't the bond prices go down?

Post by kamred » Sun Oct 23, 2016 3:09 pm

Thanks Larry, LALearning, DBR

I now understand that the correlation isn't as straightforward and most importantly the bonds will yield better with the increase in interest rates.

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Re: If the interest rates rise, won't the bond prices go down?

Post by #Cruncher » Sun Oct 23, 2016 4:47 pm

larryswedroe in this post wrote:Bond prices will fall only if rate RISE MORE than already expected as represented in the yield curve ... with the 10 year say at 1.75% and 30 day rate at .25%, the market expects the 30 day rate to average 1.75% over the full 10 years, so clearly its expecting rates to rise ... So for example if you assume rates rise at even pace over the next 10 years we will end up with the 30 day rate at about 3.5%.
I don't think many people are concerned about the effect of higher interest rates on 30-day debt instruments. But that aside, there are a couple of errors here, Larry. The minor one is that for the 30-day rate to average 1.75%, the ending value should be 3.25%, not 3.50%. The major error is that this gradual increase has nothing to do with whether the price will fall.

For example, with 30 days to maturity the price of a T Bill yielding 0.25% is 99.97948 calculated as follows: [*]

Code: Select all

99.97948 = 100 / 1.0025 ^ (30 / 365)
For the price to be the same the next day with 29 days to maturity the yield must rise from 0.25% to 0.25863%.

Code: Select all

99.97948 = 100 / 1.0025863 ^ (29 / 365)
Therefore, for the price to fall, the yield would have to rise to more than 0.25863%. If the yield increased at this pace every day, after 10 years it would be about 32%.

Code: Select all

32% = 0.25% + (0.25863% - 0.25%) * 365 * 10

* This is probably off a little bit since I don't know the Treasury's formula, but it's close enough to show my point.

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Re: If the interest rates rise, won't the bond prices go down?

Post by grabiner » Sun Oct 23, 2016 7:44 pm

larryswedroe wrote:sorry but the answer isn't YES, it is it depends. Bond prices will fall only if rate RISE MORE than already expected as represented in the yield curve


This is only partly correct. If the yield on any bond rises, the price falls by definition. Thus the value of a bond will fall unless rising rates are matched by the yield curve itself, so that the yield on that bond does not rise. An upward-sloping yield curve does not necessarily represent an expectation of rising rates; if investors expect rates to be stable, they will still demand higher yields on longer-term bonds because the longer-term bonds have more risk.

For example, if a 5-year bond yields 1% and a 10-year bond yields 2%, and all rates rise by 1% over five years, the old 10-year bond will now be a 5-year bond yielding 2%, so its price will not change. If rates rise by 1% in one year, the 10-year bond yielding 2% will become a 9-year bond yielding 2.8%, so it will lose about 7% of its value (and then get back that 7% if rates don't change over the next four years so that it becomes a 5-year bond yielding 2%).
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Re: If the interest rates rise, won't the bond prices go down?

Post by mule » Sun Oct 23, 2016 8:33 pm

Will stock funds go down also?

jalbert
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Re: If the interest rates rise, won't the bond prices go down?

Post by jalbert » Sun Oct 23, 2016 8:52 pm

The correct answer is that nobody knows what will happen to stock prices or intermediate term bond prices if and when the Fed raises interest rates, or for that matter, what would be the effect of them deciding to hold pat at any given point in time.

The fed raising rates does exert downward pressure on stock prices and upward pressure on intermediate bond prices because it is tapping the brakes on economic activity. However, a fed rate increase is usually in response to positive economic activity, which exerts upward pressure on stock prices and downward pressure on intermediate bond prices. Where the dust settles between these competing forces is quite unpredictable.
Last edited by jalbert on Sun Oct 23, 2016 10:19 pm, edited 1 time in total.

TBillT
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Re: If the interest rates rise, won't the bond prices go down?

Post by TBillT » Sun Oct 23, 2016 9:40 pm

If the Fed were to remain passive, low interest rates may be here to stay and I am tempted to by 30-yr USBonds.
However, there is a current feeling that fiscal stimulus may be needed to boost the economy, and this could cause interest rates to raise, and therefore Bond values to decline. Due to this possible scenario. bonds are slightly weak at the moment. Bottom line is that Bond values are volatile reflecting popular opinion on which way interest rates are heading (the opinion is usually wrong, but nonetheless drives short term market direction). So it's sort of a defensive period at the moment. Cash is one option.

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Re: If the interest rates rise, won't the bond prices go down?

Post by jalbert » Sun Oct 23, 2016 10:26 pm

If the Fed were to remain passive, low interest rates may be here to stay and I am tempted to by 30-yr USBonds.

Or it might allow significant inflation to return, and 30-year bonds would get crushed.

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Re: If the interest rates rise, won't the bond prices go down?

Post by pkcrafter » Sun Oct 23, 2016 10:49 pm

I think it's correct to say that the price of existing bonds will fall if rates rise.

kamred wrote:
I am curious to understand what would happen to bond prices [eg: VBMFX] when the interest rates go up. Won't the bond prices go down?

I ask because I am considering introducing bonds into my asset allocation but worry that the potential increase in interest rates will drive the bond prices down.

You are 100% stock and you are worried that a bond fund might go down if rates rise?

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

jalbert
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Re: If the interest rates rise, won't the bond prices go down?

Post by jalbert » Sun Oct 23, 2016 11:41 pm

To clarify for the OP, the Fed does not set the price or yield of bonds by raising the Fed Funds Rate. The market sets the price and yield/rate of bonds. The Fed may choose to be a market participant, such as during the so-called QE programs. The Fed might influence some bond rates to go up (and prices to go down) if and when it decides to sell bonds it acquired during QE programs (and from reinvestment of interest payments from those bonds as well as proceeds from maturing bonds in new bonds), but the market sets bond prices/yields/rates.

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Re: If the interest rates rise, won't the bond prices go down?

Post by small_index » Mon Oct 24, 2016 5:01 am

In practical terms, the yield curve will change and the trick is predicting how much it changes along the curve. If 3 year bonds rise 0.25%, that does not mean 20 year bonds rise 0.25% as well. If the yield curve rises, bond funds take a hit proportional to their duration. In effect, a bond fund with 5.5 year duration is expected to take 5.5 years to "break even" compared to no change.

A key idea, though, is that experts working at the Fed can't predict interest rates. So if you try and outguess the Fed, and they can't predict interest rates reliably, your guess is also going to be unreliable. And then you have the whole question of how much the Fed's interest rates translate to bond yield curve changes. Put simply, I'd suggest OP avoid picking the timing or type of bond fund based on your fears of an interest rate increase.

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Re: If the interest rates rise, won't the bond prices go down?

Post by topofthebellcurve » Mon Oct 24, 2016 5:05 am

Just because I love quoting Matt Levine, here's his thinking on the (largely related) topic:

Bond prices go up when interest rates go down.

Wouldn't it be funny if I wrote "bond prices go up when rates go up" and got 10,000 e-mails about it? Anyway, no, prices and rates move inversely. Perhaps you know this because you have read a financial news story over the last few decades, and it is a core tenet of journalistic ethics that every financial news story needs to contain a sentence asserting that bond prices going up when rates go down. And yet:

"When the survey asked investors what happens to bond prices when interest rates go down, over half (54%) admit they don't know," a release detailing the survey said (there's a direct relationship between bond yields and the interest rates set by central banks). "Only 22% correctly identified the inverse relationship whereby bond prices typically go up when interest rates go down. Another 17% think the two move in the same direction."

The "investors" here are "1,021 adults who live in a household with $10,000 or more in savings and/or investments," not, you know, bond-fund managers. I am increasingly skeptical of "financial literacy" as a concept. It's always treated as a synonym for knowing some finance-101 trivia, like "bond prices go up when rates go down," or "if I invest $100 at 10 percent interest compounded annually, after two years I will have more than $120," or whatever, and it seems neither necessary nor sufficient for anything. You could have a perfectly functional retirement savings plan that involves saving a lot of your income, putting it in cheap target-date funds offered by a reputable provider, and not thinking about it too much -- all without having the least grasp of how bond prices move with yields, or what yields are, or what bonds are. But knowing how bond prices move with yields will not do much to save you from Ponzi schemers, or frankly from just not saving enough money.

It seems to me that there are about two deep financial literacy questions:

1) Does your plan to finance your future lifestyle rely on miracles occurring?
2) If I offer you a 20 percent annual risk-free return, am I lying?


If you can answer those questions confidently and correctly, you can think that bond prices get purple when interest rates are hexagonal, and you'll be fine.


Full article:https://www.bloomberg.com/view/articles/2016-10-06/market-integrity-and-hedge-fund-morale

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Re: If the interest rates rise, won't the bond prices go down?

Post by garlandwhizzer » Mon Oct 24, 2016 11:49 am

The biggest risk to bonds in my view is not the Fed's expected snail-like pace of minuscule (0.25%) rises in interest rates. That is a tempest in a teapot. Bonds will in time recover nicely from that. The Fed can exert some control on short term rates, but has much less control on long term rates which largely reflect long term inflation expectations. The biggest risk to long term and intermediate term bond principle values is a significant change in the expected amount and speed of change in the inflation rate. Long term ever increasing inflation is what kills bond real returns especially so for longer duration bonds. Currently market expectations are for sustained and very low, near zero inflation rates in all DMs, lower in Japan and Europe than the US, but everywhere much lower than long term historical inflation standards. Inflation has been steadily decreasing for 35 years in the US and market participants expect that to either continue or for yields to very slowly and gradually increase from these historically low yield levels. The Treasury yield minus the TIPS rate for 10 year and 30 year durations reflect the market's expectations for 10 and 30 year future inflation. These differences are currently very low, lower by far than the average long term inflation rate. Until the market gets worried about future inflation, damage to bonds will not be a big problem. If at some point we enter a cycle of ever-increasing inflation expectations like in the 1970s and early 1980s, bonds, especially longer term bonds, will likely suffer greatly in principal value, real loses likely greater than stocks. Important to recall that from 1940 to 1980, bonds produced significantly negative real inflation adjusted returns. I don't know if such a scenario will ever occur again, no one expects it now, but if it does occur longer duration bond holders who have been rewarded greatly for decades will finally have something real to worry about

Garland Whizzer

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Re: If the interest rates rise, won't the bond prices go down?

Post by Van » Mon Oct 24, 2016 12:03 pm

garlandwhizzer wrote:The biggest risk to bonds in my view is not the Fed's expected snail-like pace of minuscule (0.25%) rises in interest rates. That is a tempest in a teapot. Bonds will in time recover nicely from that. The Fed can exert some control on short term rates, but has much less control on long term rates which largely reflect long term inflation expectations. The biggest risk to long term and intermediate term bond principle values is a significant change in the expected amount and speed of change in the inflation rate. Long term ever increasing inflation is what kills bond real returns especially so for longer duration bonds. Currently market expectations are for sustained and very low, near zero inflation rates in all DMs, lower in Japan and Europe than the US, but everywhere much lower than long term historical inflation standards. Inflation has been steadily decreasing for 35 years in the US and market participants expect that to either continue or for yields to very slowly and gradually increase from these historically low yield levels. The Treasury yield minus the TIPS rate for 10 year and 30 year durations reflect the market's expectations for 10 and 30 year future inflation. These differences are currently very low, lower by far than the average long term inflation rate. Until the market gets worried about future inflation, damage to bonds will not be a big problem. If at some point we enter a cycle of ever-increasing inflation expectations like in the 1970s and early 1980s, bonds, especially longer term bonds, will likely suffer greatly in principal value, real loses likely greater than stocks. Important to recall that from 1940 to 1980, bonds produced significantly negative real inflation adjusted returns. I don't know if such a scenario will ever occur again, no one expects it now, but if it does occur longer duration bond holders who have been rewarded greatly for decades will finally have something real to worry about

Garland Whizzer

Thank you for a straight forward and seemingly sensible explanation of what really affects the principal value of bonds.

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Re: If the interest rates rise, won't the bond prices go down?

Post by Jaxfann » Mon Oct 24, 2016 4:38 pm

Garland - thank you for yet another succinct explanation of a complex subject - I always learn from your comments and other excellent contributors to this site!

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Re: If the interest rates rise, won't the bond prices go down?

Post by saltycaper » Mon Oct 24, 2016 4:48 pm

garlandwhizzer wrote:If at some point we enter a cycle of ever-increasing inflation expectations like in the 1970s and early 1980s, bonds, especially longer term bonds, will likely suffer greatly in principal value, real loses likely greater than stocks. Important to recall that from 1940 to 1980, bonds produced significantly negative real inflation adjusted returns. I don't know if such a scenario will ever occur again, no one expects it now, but if it does occur longer duration bond holders who have been rewarded greatly for decades will finally have something real to worry about



Too late to worry at that point. They'll be grieving.
"I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said." --Alan Greenspan

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Re: If the interest rates rise, won't the bond prices go down?

Post by TomCat96 » Mon Oct 24, 2016 7:22 pm

kamred wrote:Bogleheads,

I am curious to understand what would happen to bond prices [eg: VBMFX] when the interest rates go up. Won't the bond prices go down?

I ask because I am considering introducing bonds into my asset allocation but worry that the potential increase in interest rates will drive the bond prices down.

Please share your thoughts.

Thanks,
KamRed



I think the most relevant answer to your question is this:
According to vanguard, the average duration for VBMFX is 5.8 years as of 9/30/2016.

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Re: If the interest rates rise, won't the bond prices go down?

Post by SeeMoe » Wed Oct 26, 2016 11:56 am

dbr wrote:Larry, thanks for that illuminating point.


Yes, agree . Thank you for taking the time to help answer this vexing question that I often dwell upon..

SeeMoe.. :shock:
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