Overview
- The following scenarios show that the impact of interest rate changes on your portfolio depends on whether you are holding a bond to maturity or selling it before it matures.
- Standard investment industry practice is to estimate the value of investment holdings as if they were sold on a given day at the prices of that day. This practice is called “marked-to-market.” Most bond funds and ETFs are marked to market each day.
- However, if you buy and hold an individual bond to maturity (when the bond issuer pays you the face value of the bond) all the marked-to-market periods before that maturity date are irrelevant. When the bond matures, you will likely get from the bond issuer the amount promised.
- But if you decide to sell the bond before it matures, the prevailing interest rate that bond buyers are expecting affects the price you will obtain when you sell the bond.
- The following slides show these two scenarios.
Scenario A – Buy and Hold to Maturity
Assuming the issuer of the bond, for example the US government, does not default/go out of business, you will get the interest payments and bond repayment as promised, as shown in Figure 1. Any change in interest rate over the holding period is irrelevant to you.
Figure 1 - Buy and Hold to Maturity, No Inflation
If we assume that inflation is 5% per year (coincidentally the same as the bond’s coupon rate) over the holding period, we can see that the “present value” of all proceeds from owning the bond protected the value of your money from the impact of inflation. Figure 2 below shows this result of this discounting process and the value of the yearly coupon payment in the dollars of year 0. The bond protected you from inflation and did this without a high probability of losing money because of the trustworthiness of the bond issuer.
Figure 2 - Buy Bond and Hold to Maturity, Inflation is 5%
Scenario B – Selling Bond Before It Matures
For scenario B, assume a) you want to sell the bond at the
end of year 2, and b) the prevailing interest rate environment has changed,
with bonds maturing in three years being sold with a 10% interest rate. As the
seller of the bond, you will need to compete with the other bond sellers
offering a 10% interest rate. To do
that, you will need to accept a lower price for your bond of about $87.57, shown
in Figure 3 below.
Figure 3
Figure 4
