How do interest rates affect bond values?
Over the life of a bond its market value (i.e. price) will go up and down. One of the key drivers of the price of bonds is changes in interest rates. The price of a bond rises when interest rates fall. Conversely, the price of a bond falls when interest rates rise. Expectations of changes in interest rates can also affect the price of a bond before interest rates actually change, as investors anticipate the change.
For example, let’s say you buy a 10-year bond when the market interest rate is 2%. If market interest rates then rise or are expected to rise to 3% soon after and you want to sell that bond, the person buying it will not want to pay for an asset only paying an income of 2% when they can expect to earn 3% on a similar bond. Therefore, you would have to sell the bond at a lower price than what you paid – resulting in a capital loss. Conversely, buying a bond at a 3% yield and selling it at a 2% yield would result in a capital gain (all else being equal).
Why invest in bonds?
Investing in bonds provides:
- Regular and defined income in the form of coupon payments
- Returns with typically less volatility than investing in growth assets like shares, thereby playing an important role in portfolio diversification