In theory, what effect should an increase in the national interest rate have on corporate bonds?

Question

The Bank of England is soon to announce if it's going to put its interest rate up or not. I own a lot of UK corporate bonds. Specifically, I have a big investment in one of those unit trusts that holds loads of them.

Purely theoretically, what should happen to the value of such an investment if the Bank of England interest rate goes up? I feel like I could argue it either way. For example, I could argue that the value should go up because increasing interest rates tend to make people invest more and spend less. Similarly, I could argue that it should go down because any given bond becomes slightly less valuable when new bonds start competing with it. Is there any conventional schools of economics that gives a straight answer?

Answer 1

If you own fixed-rate bonds, then rising interest rates is generally bad. Higher interest rates lowers the value of existing bonds since the coupon rate you get will be lower than bonds that are issued with higher rates. So you would take a loss if you sold the bonds, or you will not get as much "interest" (coupons) if you hold the bond than if you had bought bonds after the rate increase.

Corporate bonds always need to yield more than government bonds due to default risk. Otherwise, companies could borrow money at lower rates, buy riskless government bonds at higher rates and make a risk-free profit.

The measure that indicates a bond's sensitivity to underlying interest rates is the duration. The duration measures how much the bond's value changes for a 1% decrease in interest rates (since bond values go up when interest rates go down). So a bond with a duration of 5 will go up in value by 5% of par (e.g. from 95 to 100) if interest rates go down 1%. The higher a bond's duration, the more it is sensitive to changes in interest rates.

Answer 2

Bonds are fixed-income assets. That's because once you buy a bond, you are guaranteed a fixed amount of investment income, for as long as you own it. The fixed amount of income is based on the coupon for the bond. Almost all bonds are issued for a face amount, say 1000 pounds, with a yield expressed as a percentage of the face value (also known as the coupon), and specified life of the security, referred to as the maturity.

So, a bond might have a par value of 1000, with a yearly coupon of 5% and a maturity of 10 years. An investor can buy the bond when it is first issued or buy it from another investor in the secondary market, at any time before maturity. IF the bond is purchased at issuance, the investor pays the bond issuer 1000. For the next 10 years, the investor receives a coupon payment of 1000*0.05 = 50 every year. After 10 years, the issuer returns 1000 to the bond holder. The investor has earned 50*10 = 500 over 10 years, for his investment of 1000. See here to understand more about how a bond's coupon rate differs from its market yield.

Bonds have various risks of default, as mentioned in the question. Bonds that are backed by the full faith of a government are close to risk-free, and provide a rate of return that is very close to the central bank's overnight funding rate. Corporate bonds are backed by the assets and management ability and product or service quality of the non-governmental organization, i.e. a business or company, who issues the bonds. Corporate bonds must pay a higher rate of interest than a government bond, otherwise investors would buy government bonds instead. The higher risk the company is, the greater the coupon (interest) it will need to pay in order to borrow money, i.e. in order to find investors who are willing to buy its bonds.

There are other entities that issue bonds, such as cities (municipal bonds) and electric companies (utility bonds). These bonds are less risky than corporate bonds, but more risky than national government bonds. That is because cities and utilities have a small but real chance of bankruptcy in the event of a natural disaster or terrible management.

Changes in interest rates affect the price of a bond. In the secondary market, the price of a bond varies depending on the yield curve. For a given credit quality, interest rates on shorter maturity bonds are usually less than on longer term bonds. If interest rates increase, the price of a bond must decrease. That's what is meant by a bond being a fixed-income asset. The coupon and face value of the bond are static, and remain the same from first issuance until maturity.

• If a corporate bond's coupon is 5%, and the government raises the rate it offers on its bonds from 4% to 5%, then a corporate bond with a 5% coupon is not as good an investment anymore, as the investor isn't getting adequately compensated for the greater risk. (Central banks sometimes raise interest rates due to inflation.) As a result, the value of the bond is less, so it then must trade at a discount in order to remain competitive as an investment. In other words, the price of the bond at that point in time might decrease from $1000 to $950. The bond will still return 1000 at maturity, but in the interim, its price can be less, or greater than 1000.

• If government bond rates decrease from 4% to 3%, then the corporate bond will continue to pay out at 5% but the price of the bond will increase.

Changes in credit quality can also cause the price of a bond to increase or decrease. If the bond was considered investment-grade at issuance, but fundamentals pertaining to the issuing company's status change and get worse, then the bond price will decrease even though the coupon rate stays the same.

I have omitted details about bond math, specifically, about bond yield. Note too that terms like "purely theoretically" or "in theory" aren't meaningful in determining the impact of an increase in government interest rates on a corporate bond. The only hard and fast rule is that bond prices go down when interest rates increase. However, other considerations such as improvement or decline in the bond issuer's credit quality or the overall shape of the yield curve (referred to as liquidity preference, i.e. usually people require a higher return if their investment is tied up for 30 years than for 1 year) can mitigate or amplify the impact of changes in government interest rates.

Answer 3

To be a bit pedantic, interest changes themselves don't affect outstanding bond values. Unexpected interest increases decrease the value of bonds. If you bought a bond at a time of unusually low interest rates and the interest rate increase was expected, then it was almost certainly already priced into the bond. In fact, if the interest rate go up, but not as must as expected, that can cause bond prices to go up.

There are several ways of seeing that higher interest rates result in lower bond values. When an entity issues a bond, the final value of the bond is the interest plus the principal, with the principal being the issue price of the bond. Since higher interest means higher final price to initial price ratio, it also means a lower initial price to final price ratio (since those two ratios are just reciprocals of each other). So higher expected interest rates means that the bond will be issued at a lower price. Once a bond is issued, if the interest rates go above what was expected when the bond was issued, the market value of the bond will decrease to what a comparable bond issued now would be worth.

Another way of seeing is that higher interest rates means a higher opportunity cost of your money being held in the bond, rather than being available to invest at the higher rate. Or, if you put things in terms of discount rates, a higher interest rate means a higher discount rate, which means that the current value will be depressed relative to the face value to a greater degree.