Bond Market Math (Part 2)

If rates are rising, how do bond investors make money?

When rates go up bond market values go down. The return from bonds doesn’t come from the market, but from the coupon. That’s the interest rate promised when a loan is first made, and it compensates investors for the risk.

So in order to invest profitably it’s important to understand the risks involved. Bonds have three principal types of risk: interest rate risk, credit risk, and structural risk. Interest rate risk is clear: bond prices go down when interest rates rise. The longer the bond, the more the price declines for a given interest rate move. For example, a five-year treasury will fall 4.7% if rates rise 1%, while a 30-year bond will fall 15.7%.

That’s why long bonds yield more than shorter bond normally—to compensate investors for the greater risk. But with rates rising, investors have to find other sources of return. So credit risk and structural risk are crucial: sources of risk can also be sources of return. As rates rise, structure and credit become the key to unlocking future bond market performance.

Douglas R. Tengdin, CFA

Chief Investment Officer

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