With interest rates for bonds so low and bond prices so high many fixed income experts think that we are in a bond bubble. Some bonds such as the Germany’s 10 year bond are selling at a negative interest rate.
A COMMON MYTH IS THAT BOND INVESTMENTS ARE SAFE INVESTMENTS
- When interest rates decline the price and principal of the bond increases.
- When interest rates increase the price and principal of the bond decreases.
- Bonds with a greater duration ( maturity) will increase or decrease more than a bond with a shorter duration.
- (Formula) Total bond return = yield plus capital appreciation.
Interest rates increase 1 percent. What is the impact on the bond total return for 10, 5 and 2 year bonds
Total Return for 10 Year = Yield (1.7%) + Appreciation ( – 10%) = Total Return = Minus 8.30%
Total Return for 5 Year = Yield ( 1.5%) + Appreciation ( – 5%) = Total Return = Minus 3.5%
Total Return for 2 Year = Yield (1.5%) + Appreciation ( – 2%) = Total Return = Minus .50%.
Takeaway is most bond investments in a rising interest rate environment (unless the bond is held to maturity) have negative total returns. The longer the maturity of the bond, the greater the negative return. Conversely, when interest rates decline, the bond with the longer maturity has a greater total return than the bond with the shorter maturity. Therefore, the strategy is to purchase bonds when interest rates are high and are trending down, and not to purchase them when interest rates are so low that they are unlikely to go much lower.