Understanding Fixed Income - Interest Rate Risk

One potential misconception about fixed income investing is that it does not entail risk and that bonds always produce predictable, stable returns. While it is generally true that bonds are less volatile than stocks, bond investments are still subject to price fluctuations that can be material at times. Therefore, like any other investment, it is prudent to understand the drivers of fixed income performance in order to avoid taking on unintended risk.

Interest rate risk is the risk that changes in prevailing market interest rates will adversely impact the price of an existing bond. Virtually all bonds are subject to interest rate risk to some degree, and this is the primary source of price volatility for high quality bonds such as U.S. Treasury securities.

When a bond is first issued, it is assigned a “coupon rate” which determines the amount of interest the bond will pay its owners annually. For most bonds, the coupon rate remains the same throughout the bond’s life¹. For example, on September 3, 2019, the United States government issued a Treasury bond maturing on August 31, 2026.² This bond carries a coupon rate of 1.375%, meaning an investor who purchases $1,000,000 of principal value of this security is paid $13,750 in interest each year until the bond’s final maturity date. At maturity, the $1,000,000 of principal is also repaid.

An important determinant of a bond’s coupon rate is the prevailing level of market interest rates at the time the bond is issued. When interest rates are low, coupons on newly issued bonds are also generally low. The same correlation occurs when market rates are high. However, while a particular bond’s coupon rate is permanently set, market interest rates change daily. Over time, this often leads to a divergence between the existing bond’s coupon and the coupon a new bond with the same maturity would have if it was issued today.

To illustrate this, consider the Treasury bond in the above example. Two years later, a different Treasury bond was issued with an identical August 31, 2026 maturity date.² Market interest rates were lower in August 2021 than they were in August 2019, and the newer bond carries a lower coupon of 0.75%. These two bonds were issued by the same entity, the U.S. government, and mature on the exact same date. The only material difference between them is that the older bond pays its holders a higher coupon. For a $1,000,000 principal investment, this higher coupon translates into an additional $6,250 in interest per year. Therefore, all else equal, any rational buyer would prefer the older issue to the newer one.

The bond market solves for this dilemma by adjusting the price of previously-issued bonds to reflect current market interest rates. A buyer of a bond with an above-market coupon will have to pay a higher purchase price to own the bond. This higher up-front price compensates the seller for giving up the additional coupon income over the remaining life of the bond. Likewise, a bond with a below-market coupon will trade at a discounted up-front price to compensate the buyer for accepting lower interest payments over the remaining life of the bond.

Returning to the Treasury example, if the market is efficient, the price of each bond should settle at a level which makes the buyer essentially indifferent regarding which one to purchase. In fact, we can see this happening in the market. On November 30, 2021, $1,000,000 of principal value of the newer bond could be purchased at a discounted price $982,813, while $1,000,000 of the older bond with the higher coupon commanded a premium price of $1,012,188.² The difference in up-front price offsets the difference in coupon rate such that a purchaser of either bond could expect to earn roughly the same annualized return (or yield) over the remaining life of the bond.

This example helps to illustrate how and why bond prices fluctuate and why bonds are not “risk-free” investments. It is possible to buy a bond (or a bond fund) and have that investment’s value change, perhaps materially, if market interest rates change subsequent to purchase.

Therefore, when investing in bonds, a few rules of thumb are worth remembering:

• The total return on a bond investment consists of two components:
  a) The coupon income paid by the bond each year.
  b) The change in the price of the bond during the period it is held by the investor.
  The return of a bond fund is simply the weighted average return on all of the underlying individual bonds.
• Bond prices generally move in the opposite direction of market interest rates. When market rates fall, prices of existing bonds tend to rise. The opposite is true when market rates rise.
• The price of a longer-dated bond is normally much more sensitive to changes in market rates than the price of a shorter-dated bond. The buyer of a longer-dated bond will receive the off-market coupon rate for a longer time. Therefore, the up-front premium or discount in the purchase price should be larger to reflect that.
• A bond’s coupon rate may not be indicative of its future return profile. Instead, the bond’s yield to maturity is a more accurate measure because it accounts for both the coupon income and the discount or premium in the bond’s price.
• Historically, market interest rate movements have often been correlated with stock price movements (i.e., rates tend to drop and bond prices tend to rise when stock markets fall). This is a reason that high quality bonds, particularly longer-dated bonds, can be used to potentially dampen a portfolio’s sensitivity to stock market movements.

1. There are exceptions to this, the most common of which are floating rate bonds. Floating rate bonds have a coupon that resets on a specific schedule (e.g., every three months). Additionally, some bonds, known as “zero coupon bonds” or “strips”, do not have a coupon at all and are traded at a discount to their maturity value. The bond market is home to a variety of other esoteric structures as well, but the majority of issues are relatively simple fixed coupon, fixed maturity bonds.
2. U.S. Department of Treasury, treasurydirect.gov.