Interest Rate Risk
- or -
Do Prices Always Go Down When Rates Go Up?

Interest Rate Risk - or - Do Prices Always Go Down When Rates Go Up?

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s the secular decline of interest rates that has been taking place for the last twenty years seems to be coming to a halt, this might be a good time to review what will happen to bond prices if interest rates remain steady or even begin to increase.

The fixed income market encompasses a wide array of structures other than U.S. Government issued treasury bonds. In addition, there are agency bonds; corporate bonds, both investment grade and speculative; asset-backed or "collateralized" bonds of many types; mortgages; convertible bonds; and many more. Even many stocks that trade on national exchanges behave more like bonds than stocks, in that they have fixed dividends (coupons) and a defined maturity.

All of these instruments respond to changes in interest rates. But it is not necessarily as simple as that. While interest rates are important, they are not the only consideration when assessing risk. Even though rates and prices usually move inversely to one other, there is plenty of variation in both the direction and actual magnitude of this relationship. In addition to interest rates, some of the major risks which should concern investors are term structure, credit, and prepayment. Let me define these terms.

Term structure risk refers to the slope of the yield curve. Not only are long and short term interest rates different, but they will often move separately. Take 2004 as an example. While short term rates have gone up from 1% to 2% this year so far, longer term rates like the ten year treasury have gone down from 4½% to 4%. So even though the Federal Reserve has increased rates, longer term rates have actually come down, causing prices on longer maturity bonds to increase. But before you celebrate, remember that the opposite can happen; an environment of lower short term rates can depress bond prices. This phenomenon, of different maturity rates moving in opposite directions, can produce and is thus called a flattening or, conversely, a steepening of the yield curve.

The next type of risk, credit, impacts every non-U.S. Government issuer of debt. The yield, or borrowing cost, for these issuers is greater than a Treasury counterpart of the same maturity. This difference is called the spread of the issuer, and it represents an insurance premium against the possibility of default by that issuer. In the event of default, all future interest and principle payments on the debt are compromised. In exchange for bearing that risk, the investor receives a yield that is at a premium to treasury debt. This is a good thing, as long as the bond does not go into default. The magnitude of the spread actually represents the probability that the issuer will go into default. Issuers with a low probability, that are financially sound, will have a lower spread than more risky companies. The difference in spread between investment grade debt, typically around 1% and high-yield ('junk') debt, typically around 5% reflects the dramatic difference in their probability of default, or the relative risk to the investor.

The market is always evaluating the probability of default in the same way it evaluates what interest rates should be or what the price of a stock should be, and the spread for every issuer will move accordingly. If interest rates are unchanged, but the markets perception of a company deteriorates, their spread will increase and their bonds will decline in value. It is even possible for general interest rates to decline, but for a spread to widen by more than that decline, causing a corporate bond to decline in value even though interest rates elsewhere seem to be falling. The lower the credit worthiness of a bond, the more spread changes will play a role in the determination of price movement. At lower credit quality, the market's perception of credit-worthiness has a greater impact on price movement than does the movement of interest rates.

Example: The table below lists the value of a $100 par investment in a hypothetical 5 year bond with a 5% coupon, At the top of each column is the yield for a five-year treasury security and the rows are differentiated by the spread of this particular issuer. The first row is the price of the actual 5 year treasury.

Treasury Yield

Note that at each yield level the corporate price is lower than the treasury, because of the spread on the bond. And while, the corporate prices still decline as yields go up, the decline can be even greater than expected if the spread increases, or credit-worthiness of the issuer declines.

The last type of risk addressed concerns prepayment. Prepayment influences the price of a bond by affecting its maturity. Mortgage-like securities are most sensitive to this type of risk and display a most interesting property. In general, as yields decline, prices rise. Why is this? Simply put, a bond is an agreement to pay/receive a certain interest rate over the life of a loan. Usually, the terms of the loan, its interest rate and its maturity, are decided at the outset. If rates decline, the lender is in good shape, because the lender has locked in an interest rate that is now higher than the prevailing market rates. This will cause the price of the loan to increase, because it will be paying at the higher rate for some time to come. From the perspective of the borrower, this is a bad thing, because he is now paying at a rate over what he could, if he took the loan out today.

But a mortgage is not an ordinary loan. The borrower, at his discretion, can refinance and pay off the original loan. The lender loses out on this deal. If rates go up, he is obligated to the original terms of the loan, continues to receive a lower than prevailing rate and cannot change the terms of a fixed-rate loan. The borrower on the other hand wins, because if rates move in his favor, in that they decline, he gets to walk away from the loan and refinance at the lower level. Mortgage rates are higher than treasury rates to provide the lender with a premium to be protected from this asymmetric event. This premium though is only an estimate, or some type of average, of what insurance is needed by the lender, or the investor. As interest rates decline, some mortgage prices may actually decline in value due to the fact that prepayment is shortening the maturity of the loan, albeit that it possesses a higher than market coupon.

Again, an example will be helpful: Consider a mortgage security with a 5% coupon. In this example, we use a typical thirty year fixed rate mortgage security as the example, though the effect we will illustrate is common to most types of mortgage securities. In fact in the world of mortgage securities, this is a rather benign example of what can happen. Again, the top row gives the price for a 5 year treasury with a 5% coupon, a bond with roughly the same amount of risk as the mortgage in question. The second row lists the price of the mortgage today as well as the case where yields go up 1% and down 1%.

Treasury Yield

Note that when rates decline, the mortgage does not appreciate by as much as the treasury. This is because the effective maturity has declined due to higher anticipated prepayments. Though the coupon of the bond is higher than the prevailing rate, the lender will not be receiving it for as long as he expected. Conversely, when rates rise, the mortgage is paying a lower coupon than prevailing rates. Due to lower prepayments, the bond will be around longer than originally expected and the lender must accept the lower yield for a longer time, hence the depreciation is more than for the treasury. This phenomenon, where declines are more than expected, and gains are less than expected are characteristic of the mortgage market and can be more severe than illustrated here. In fixed-income terminology this is called negative convexity. The benefit of this though, is that mortgages carry a higher yield than comparable maturity treasury securities as a way to insure against this condition.

Two other types of bonds are worth mentioning. The class of bonds named "callable" or "putables" will tend to behave like mortgages, in that their maturities, though stated upfront, may change as interest rates move. Again this movement will have an asymmetric effect, sometimes to the issuer's advantage requiring a yield premium, and sometimes to the lenders advantage, causing a yield discount. Investors should also be aware of a family of bonds called "convertibles" whose price depends not just on interest rates but on specific stock prices as well. These bonds will have additional risks, such as a dependence on equity prices.

Of course, there are bonds that possess any combination or even all of the risks addressed above. And finally, a note about bonds called "structured products." These are bonds whose interest and principal payments can be linked to absolutely anything: stock indices, foreign exchange rates, the slope of the yield curve, oil prices or even the number of hurricanes that occur in a given region in a given year. Indeed there is very little that is fixed in the world of fixed income!

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Steve Pomerantz PhD provides economic consulting and litigation support. He can be reached at steve@stevepomerantz.com