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Understanding bonds

Adapted from an article published by David Baskin, RPB's Investment Committee Chair, on May 18, 2022

Usually, when the stock market is falling, as it is now, investors can take some comfort in the fixed income portion of their portfolio to provide some stability: At least their capital is protected and returns are predictable, even though they are lower over time than stocks.

That's what usually happens. However, the last six months have seen the biggest drop in the bond market in history.

The cause is the rise in interest rates around the world. As central bankers look for ways to reduce inflation, which is running as high as 7% per year in some places, their first reaction is to raise interest rates. The hope is that higher interest rates will cool the real estate industry, lead to lower demand for consumer goods, and thus lower prices. As the chart below shows, the interest rate on the five-year US Treasury Bill has gone from about 0.5% last August to about 2.77% today. That is a very significant increase, particularly since the five-year T-Bills is a key benchmark for mortgages and consumer loans.

The interest rate on the 5-year US Treasury Bill has gone from about 0.5% last August to about 2.77% today

Many people find bonds confusing, and don’t really understand why they go up and down in value. Some RPB participants may wonder why RPB's Tier 1 Fixed Income investments have lost some value so far in 2022.

The math involved in bond pricing is pretty simple, but it is the exact opposite of what most people expect. Please take a few minutes to read these examples—after you do, you'll find bonds aren't really that mysterious at all.

Example #1

Imagine that Fred, your next door neighbor, comes by your house and says “I need $100. Can you lend me the money for a year? I’ll pay you $2 of interest.” You trust Fred and agree to the deal. You are now the owner of a bond that has the following characteristics:

Issuer: Fred, high credit quality (Fred always pays his debts)

Face Amount: $100

Interest rate: 2%

Maturity: One year from today, May 18, 2023

That’s pretty much how all bonds are described, except you will sometimes see the description reduced to shorthand like this: FRED 5/18/23 2.00% 100.

The day after you loaned the money to Fred, the Federal Reserve announces that it is increasing interest rates by 2%. You are upset. You could go to Fred and say, "Interest rates are now 4%, not 2%. Can we renegotiate?" Fred will likely tell you that a deal is a deal. So, you decide to sell your bond to your neighbor Sally across the street. You walk over and tell her you own $100 of FRED 5/18/23 2% bonds. Would she be interested in buying? Well, she says, sure, Fred is a great credit risk. I will be happy to pay you $98 for your bond. You are even more upset! You know, and Sally knows, that a year from now the bond will pay $100! Sally is asking for $2 for free, and you are looking at a 2% loss. Sally patiently explains that she can lend $100 to her buddy Cindy down the street at 4%, the new interest rate. A year from now she would have $104, a $4 profit. If she buys your FRED bond for $98, and gets $2 interest, she will also make $4. Either deal is the same for her.

You are grumpy and decide not to sell. A year later Fred gives you $102 consisting of the $100 you loaned him, plus $2 of interest as agreed. You didn’t lose money - in fact, you made $2 - but of course, had you been lucky and loaned Fred the money a day later, you would have made $4 instead of $2. What you did lose was opportunity, the chance to make a bigger profit. You console yourself with the fact that it was only one year, and now you can reinvest the $102 at 4%.

In the bond market, the day that interest rates went up, the value of the FRED bonds went down, in this case, by 2% to $98. If held in a brokerage account, the bonds would be “marked to market value” and would be shown with a market value of $98 instead of $100. Each day of the year, however, the bonds would be marked up a little bit as they got closer to maturity. Six months from issue, they would be worth $99, nine months from issue, $99.50, and finally, on maturity date, $100.

There are three important points from this example:

  • When interest rates rise, the market value of bonds fall.
  • Market value does not mean you will not get paid the face value of the bond; it is simply what somebody will pay you for the bond today.
  • The closer the bond gets to maturity, the closer its market value will get to face value.

Example #2

Fred needs $1,000 to paint his house but he can't afford to pay it back in one year. He visits you and says “If you loan me $1,000 for ten years, I will pay you interest of 5% per year, and the full $1,000 at the end of that ten years”. Now that you know bond language you know that you can describe this bond as FRED 5/18/32 5.00%. You think that’s a pretty good deal. Short term bonds are paying only 4%, so Fred is giving you an extra 1% per year for loaning him the money for a long period. You make the deal. A week later, the Federal Reserve, fearing a recession, drops interest rates back to 2%.

Sally hears that you did a deal with Fred and comes to visit. She asks if you would like to sell your FRED 5/18/32 5% bonds. Naturally, you ask how much she is offering. Sally says “I could buy some other new 10-year bonds, but they only pay 3%, since the Federal Reserve dropped the rate. Your FRED bonds pay an extra 2% per year. On $1,000 that’s an extra $20 per year; over 10 years, that’s an extra $200. I guess I would pay you $1,200 for your ten-year 5% FREDs. I know that I will only get $1,000 when Fred pays them off, taking a $200 loss, but in the meantime I will get more interest each year than what I would get on a new bond."

You are thrilled with the idea of making a fast $200 profit – 20% on your $1,000 investment – but then you think about it and realize that you will now have to reinvest that $1,000 in a bond that is paying only 3% instead of the 5% you are getting from Fred. Should you trade the extra $20/year for a fast $200 now? You also recognize that if you don’t sell, the value of the FREDs in your portfolio will be “marked to market” and the $1,000 bond will have a market value of $1,200. It’s not money in your pocket, but it sure looks nice!

These two examples illustrate how the bond market works:

  • When interest rates go up, the value of existing bonds are marked down. When most bonds are issued, the amount of interest paid is fixed. When rates rise, the price of the bond will be reduced to the level required to pay an investor an equivalent rate of return. When the bond matures, investors should still get paid the original loan amount; therefore, as the bond nears maturity the price will increase/decrease to be in-line with the original loan amount. This market adjustment makes sure that all investors are able to earn the same level of return as interest rates change.
  • When interest rates go down, the value of existing bonds are marked up, since they now offer a higher yield than is available on newly issued bonds. When rates fall, the price of the bond will increase to the level required to pay an investor an equivalent rate of return. When the bond matures, investors should still get paid the original loan amount; therefore, as the bond nears maturity the price will increase/decrease to be in-line with the original loan amount.
  • The time to maturity also has a drastic effect on market value changes. The longer the time to maturity, the greater the price change will be on a bond as interest rates change. On the one-year FRED bonds, a 2% change in interest rates only caused the bond to drop in value by 2%. If you invested in a 10-year FRED bonds, a 2% change in interest rates caused the market value to jump by 20%.

The changes in bond market values happen every day even if the holder has no intention of selling the bonds, but the changes in value are only realized if the bond is sold.

RPB's investment lineup includes bonds in both the Tier 1 and Tier 2 funds. The fixed income portion of each of the Tier 1 funds consists of a mix of short to intermediate term bonds. The funds' investment managers are responsible for managing market and credit risks. Tier 2 has three separate bond index funds—two short term bond funds and one fund that provides broad exposure to U.S. investment-grade bonds.

If you have questions about your RPB investment allocation, we encourage you to speak with your financial advisor or call Fidelity's retirement planners at 800.328.6608.

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