If bonds' current yields soar, then should you hold yours until maturity?

Question

[Source:] To be able to hold a bond to maturity, you need to have the discipline to hold on, even if the value shifts dramatically. In 2012, that means that if our ridiculously low interest rates go away and the rate for a high-quality 30 year bond goes up to 12% in 2017, the value of your 3% bond will nose-dive. Do you have the discipline to stay the course and not panic?

1. Amid this increase in current yields on OTHER bonds, the smartest choice is to retain YOUR bond until maturity, right? Is the excerpt above recommending this, but only questioning the bondholer's disclipine to do so? Or is it suggesting otherwise?

2. Am I right that: the holder's 3% bond will nosedive, because current yield inversely correlates with bond price?

Answer 1

Regarding wether to hold the bonds or not, the reason the price of the bond nosedives in the first place is so that at the margin, its price will be such that it would have roughly the same yield to maturity as bonds of similar maturity (all else equal, credit quality, liquidity, etc...)

In other words, the investor would be indifferent between selling it or holding it if they did not have any views on prevailing interest rates.

One of the factors that would drive the investor's decision to trade it is also mentioned in the original question.

1. There may be tax considerations.
2. The investor has some sort of view regarding interest rates (i.e. they are going up/down rapidly) and would like to take a chance to buy new bonds at much better yields.

Answer 2

I think the answer above is mostly right, but there is one important detail that can be misleading. I disagree that the investor would be indifferent between selling and holding if they have no views on the evolution of interest rates. They would be selling at a large discount to what they purchased (in our hypothetical rate spike scenario), likely incurring a loss far in excess of any received coupons up until that point.

It would be more accurate to say that they would be indifferent from buying that, now discounted bond (with a low, 3% coupon), and buying the new, par valued, 12% coupon bond.

In regards to your first question, you would hold until maturity, assuming no default risk (credit risk is different from interest rate risk), because presumably when you first purchased the bond you were satisfied with the stated yield to maturity, which you will still receive. If you sell, you are going to lose money.

For your second question, current yield is just coupon / price. So yes, it shot up because price dropped, but the coupon stayed constant. The important relationship here is yield and price, which are inversely related. Think of it this way: the bond you bought in this scenario pays 3%, and will until maturity. When you bought it, if market rates were 3%, it priced at 100 (par). Now, if market rates are 12%, a newly issued bond would have a 12% coupon to trade at par. This means a new buyer would only be willing to buy the 3% coupon paying bond at a discount big enough to cause the yield to maturity on that bond to be equal to the yield to maturity on the 12% coupon bond, which is a really big discount.