After last week’s FOMC meeting, the time when interest rates begin a sustained rise propelled by the Federal Reserve may be drawing closer. The received wisdom is that no one should own bonds when interest rates are rising because rising rates mean falling bond prices. While the math demands that bond prices fall, a deeper look at the math reveals that all may not be lost.
Some investors believe that the yield to maturity on a bond measures the return they will earn if they hold the bond until it matures. Not quite. There is a hidden assumption that the coupon payments received every six months will be reinvested and will earn the same rate as the yield to maturity. Since interest rates can vary over time and different rates are available for different time frames, this assumption rarely holds. When interest rates climb after a bond is issued, the price of the bond drops but the returns earned from reinvesting the coupon income benefits from the higher interest rates. (The reverse also holds, if rates fall after the bond is issued, its price rises but the returns or “interest on interest” from reinvesting the coupons is less.) If you buy a bond and interest rise far enough and fast enough, you might do better than if rates never moved at all.
A made-up example shows how this might work and how the investor who holds the bond long enough could benefit. The table shows a theoretical investment in a 2.5% coupon ten year Treasury note bought on January 15, 2015 at a price of 100. The yield to maturity when purchased is 2.5%. If rates don’t change and if each semi-annual coupon payment of $1.25 can be invested at 2.5% annual rate for the remaining life of the bond, the investment will be worth $128.20 on January 15, 2025 when the bond matures. The dashed purple line on the graph illustrates this; the right hand scale is the value of the investment in the bond and the coupons.