When interest rates go up, the cost of capital increases. How does this impact investors, or why should they even care? Specifically for bond investors, the fluctuations in interest rates can significantly impact their investments.
Getting back to the question about the cost of capital and why investors should care, it’s because companies may issue bonds at a higher interest rate. If investors choose between a lower coupon rate vs. a higher one, they’re more likely to choose the higher rate.
Interest Rates And Bonds
Bond prices have an inverse relationship to interest rates. As interest rates rise, bond prices fall and vice versa. This happens because investors are more interested in the higher rate bond (i.e., higher coupon payments) than the lower rate bond. As demand for the lower rate bond drops, so does its price.
From the perspective of a bond issuer, it’s a similar scenario. For example, CompanyA issues a 5% bond. Other companies begin issuing bonds at higher rates to attract capital as the economy grows. To be competitive, CompanyA must increase its new bond offerings from 5% to 6%.
Risks associated with CompanyA have not changed just because its interest rates are higher. This means 6% bondholders are assuming the same risk as 5% bondholders, making the 6% bond even more attractive (i.e., a higher reward for the same risk).
In summary, if you are receiving 5% per year, the value of that payment goes down as inflation and interest rates go up. Your purchasing power is decreasing on the 5% coupon payment. On the other hand, the 6% coupon payment has increased with inflation, increasing purchasing power.
The above scenarios are called interest rate risks. Some other examples of interest rate risks include:
- Fixed coupon bonds
- Cash — if interest rates or inflation begins going up, the value of cash goes down
Some examples of low-interest rate risk include:
- Commodities (gold/oil) - commodities go up when interest rates go up
- TIPS (Treasury Inflation Protected Securities) — coupon rate adjust with inflation (up or down)
- Stocks — partially hedged against interest rate risk
Investors who reinvest their coupon payments into new bonds at a lower rate can experience reinvestment risk.
Reinvestment risk occurs when reinvested cash flows (from coupon payments) decline or generate less income than current investments. For example, an investor reinvests payments from a 5% coupon bond into other bonds. However, if interest rates fall to 4%, the investor will have to reinvest at a lower rate.
Callable bonds also present reinvestment risk. The issuer can call away a callable bond. This ends the coupon payment and returns the principal to bondholders. With a callable bond, cash flows are not known with certainty since you don’t know if or when the bond will be called.
For example, if an investor is issued a 5% bond and rates drop to 3%, the borrower will likely call the bond and issue a cheaper bond. The investor loses cash flows while the principal is returned earlier.
What can an investor do to manage reinvestment risk better?
Managing Reinvestment Risk
Zero coupon bonds are one way to manage reinvestment risk. These bonds don’t make periodic interest payments. Investors only have to think about investing at face value. Zero coupon bonds are sold at a discount price because of the date discounts on their face value.
Investors can also invest in non-callable bonds. These bonds are also called non-redeemable since the issuer cannot call them in until maturities and penalties are paid to the bondholder.
Portfolio diversification is another method for managing reinvestment risk. Diversification helps reduce the chance that all investments will perform poorly.
By understanding the relationship between bond prices and interest rates and also working with a financial adviser, investors have a better chance of navigating potential reinvestment risk.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Examples shown are hypothetical and for illustrative purposes only. This is a hypothetical example that is demonstrating some mathematical principles. It does not illustrate any investment products and does not show past or future performance of any specific investment. Investing involves risk, including the loss of principal. A bonds yield, share price and total return change daily and are based on changes in interest rates, market conditions, economic and political news, and the quality and maturity of its investments. In general, bond prices fall when interest rates rise and vice versa. You could receive back less than you initially invested and, unless otherwise noted, there is no guarantee that you will receive any income.