The Impact of The Fed’s Interest Rate Hike on Bonds
Good Morning Relaxing Retirement Member,
With the Federal Reserve’s recent (and extremely long overdue) interest rate hike, I have received a lot of questions from Relaxing Retirement members on the impact this and future interest rate hikes may have on bonds.
This is a very good question. There is a lot of confusing information in the news, so let’s take a moment to review the relationship between bonds and interest rates.
Interest Rates and Bonds
To better understand the big picture relationship between bonds and interest rates, assume for a moment that you purchased a $100,000 AAA rated, long term corporate bond in 2006 for $100,000. Let’s assume the bond’s coupon rate was 7%, and you are still holding that bond today receiving interest.
If another investor has $100,000 to invest today and is searching for a similar bond, he or she can find one, but it will not pay 7%. It will pay in the 4.00 to 4.40% range.
If that investor wanted to buy your bond from you in an effort to earn 7%, you would never sell it to him for $100,000 (par value) because you could never go out and find another new bond paying 7% given today’s low interest rate environment.
To entice you to sell him your 7% coupon bond today, the buyer would have to pay you significantly more, perhaps $110,000 or more, in order to compensate you properly.
As interest rates in the economy rise, and the interest rate paid by newly offered bonds in the market rises from 4% to 5% to 6% to 7%, etc., your 7% coupon bond becomes less and less attractive to them. The result of this is your bond falls in value from the current market value of $110,000 you could receive if you sold it today.
Additionally, at maturity, the bond will return the original purchase price of $100,000 to the holder of the bond. In other words, if held to maturity, the owner of the bond will now watch his or her bond, which is currently valued at $110,000 or more on the open market, fall in value to $100,000.
This is the big picture state of the bond market today, and the dilemma for everyone holding a long term bond, or considering the purchase of an existing bond on the open market.
When interest rates in the economy fell lower and lower, the value of existing bonds in the marketplace rose dramatically. This is where we have been for some time.
When interest rates now begin to tick up and up, the market value of those appreciated bonds have no place to go but down. It’s not a matter of if. It’s only a matter of when.
This is why the flight out of stocks into bonds after the slightest correction over the last few years is so detrimental, especially long term bonds. All of those bonds were purchased at a very high price (over par) and the value has no place to go but down because interest rates have nowhere to go but up.
While all bonds are affected by interest rate movements, those most affected by this are long term bonds and bonds of lower quality which had to compensate investors with much higher interest rates in order entice them to buy.
This is the main reason why we made the move long ago to higher quality and shorter duration bonds for the bond portion of our Relaxing Retirement members’ Retirement Bucket™, and why I would strongly urge everyone to do the same.
I hope this has been as helpful for you as it was for the members I have spoken with. I recognize that it is very broad, but it should give you ammunition going forward.
Please don’t hesitate to reach us with any questions.
Committed to Your Relaxing Retirement,
The Retirement Coach
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I appreciate the trust you place in me. Thank you! (The content of this letter does not constitute a tax opinion. Always consult with a competent tax professional service provider for advice on tax matters specific to your situation.)