What Will Happen to the Bond Market When Interest Rates Rise?

As a retail investor, whether you do your private banking in Paris, Bangkok, or New York, you’re likely to have some skin in the game when it comes to the bond market. Investment in bonds is an important step to diversifying your portfolio. However, bond investors are on edge, as are all investors, wondering what will happen if and when the Federal Reserve raises interest rates. Take a look below to learn more about the effects of rising interest rates on the bond market.

The correlation between bond price and interest rates

The bond markets change rapidly in response to economic and fiscal factors, including exchange rates, inflation, and Federal Reserve decisions about interest rates. In the midst of expectations of increasing interest rates, bond values are changing. The general consensus, whether from financial markets in New York or private banking Paris, is that rising interest rates will generally cause bond prices to fall. But rises in rates don’t affect prices equally. Bonds with longer maturity periods typically lose more value when rates increase than those that take less time to mature. This means that ten-year bonds typically stand to lose more of their total value when rates rise than two-year bonds do.

Other factors affecting interest rates

In addition to period of maturity, other factors play a role in bond prices. Lower “coupon rates” for bonds will cause price to react more strongly to rises in rates. Further, variable rate bonds tend to retain their value better than bonds with a fixed rate. However, investor behavior is just as important as any of these factors. Regardless of whether a bond matures in two years or twenty, if an investor keeps the bond until maturity, increasing interest rates won’t affect the amount of income received. This is because at maturity, investors receive “par,” or face value plus the interest that accrues throughout the life of the bond, beginning upon the bond’s purchase.

When you need to sell

What happens if you find yourself needing to sell bonds in a period of rising interest rates? Selling before maturity does certainly pose a risk. If you sell before your bonds mature, rising interest rates may have caused their value to drop. Selling at a loss is likely given the inverse relationship between interest rates and bond price. If you can wait to sell until your bonds mature, or better yet, when interest rates go down, you’ll be better off financially. Selling bonds when interest rates go down allows you to reap capital gains, meaning that your bond is now worth more than it would have been before the drop in interest rates.

When to buy bonds

When making a decision about whether to buy or sell bonds, it is important to contact your financial advisor. Most banks encourage you to maintain a diversified portfolio, which consists of stocks, bonds and liquid investments. The ratio of stocks to bonds will depend on various factors, including your level of desired risk, your investment objectives, your age, and other factors. Financial advisors, whether through banking institutions in the United States or private banking in Paris or London, can help guide you to choose the appropriate bonds for your portfolio so that you can achieve your financial goals.