When it comes to bonds and the impact of interest rate increases on investment portfolios, investors can be left scratching their heads. Whether it is via a credit card, personal loan, or a home loan, most investors have experience with interest rates. When it comes to bonds and the impact of interest rate increases on investment portfolios, investors are often left scratching their heads.
Source: The Corporate Finance Institute “What is a coupon bond”. Data as at 22 April 2022. For illustrative purposes only.Let us illustrate this using an example: Company A issues a new five-year bond with a face value of R1 000 and an annual coupon rate of 10% of the bond’s face value. In this case:
Would an investor purchase Bond A with a coupon rate of 5% if they could buy Bond B with a higher coupon rate of 5.5%? Probably not – which means that the price of Bond A now needs to fall to attract buyers when compared to other bonds with higher coupon rates/yields. The below graph illustrates simply how duration works – with an interest rate spike of 1%, a bond with 0 years duration will have no drop in price, whereas a bond with four years duration will see a 4% drop in price.
The graphs below illustrate the aforementioned point by showing the maximum and minimum returns of US equities and the US 10-year treasury bond since 1928. The range of returns of equities is very wide over one year and ranges from a minimum of -43.8% to a maximum of 52.6%. There have been two unforeseen shocks to the market putting pressure on inflation: the Russian invasion of Ukraine and the hard lockdown implemented in China in response to a rise in Covid-19 cases. These shocks were not forecastable and have put upward pressure on inflation through supply disruptions.
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