Quizmaster, Doug Hutchinson, presents his quiz for the month. This time he explores the impact of declining interest rates on bonds. Keep reading to find out if Patricia should have sold her bond.
Consider this scenario:
Your friend Patricia is concerned about the impact that an increase in interest rates will have on the return of a bond that she owns. She owns 50,000 par value of a bond with a 3% coupon that pays semi-annually and is currently trading at $102 (102% of par value).
"I know that when interest rates go up, the price of a bond will go down," she tells you. "So I'm considering selling this bond that I own because I don't want to suffer a negative return on my bond."
Patricia ultimately decides to not sell her bond.
Exactly one year later, you see Patricia again and she tells you: "Interest rates drifted higher over the last year and the price of my bond declined from $102 last year to $101 right now. I knew I should've sold this bond one year ago. If I would've sold my bond I would've avoided the negative returns on my bond that I suffered over the last year."
Is Patricia correct in her assessment of the performance of her bond over the last year?
For the purpose of this example ignore all other factors such as custody fees, trading costs, taxes, other fees, etc. Also, assume that the bond issuer makes all interest payments on time and in full.
Solution:
Patricia had a positive return on her bond over the past year. The decline in the price of the bond was more than offset by the interest received on the bond.
Start: $50,000 x 102% = $51,000 value
One year later: $50,000 x 101% = $50,500 value
Income received = $50,000 x 0.03 = $1,500
The holding period return = $1,500 + ($50,500 - $51,000) / $51,000 = 1.96%
A bond going down in price does not necessarily mean that the holding period return on the bond will be negative. It turns out that the income that Patricia received more than offset the decrease in the price of her bond, leaving her with a positive return on her bond over the last year.
Check out another quiz from Doug's Quiz Corner!
To learn more about some of the factors that may affect your return and to discuss your strategy give us a call at 1-800-541-7774 or contact us here to get in touch with one of our Wealth Managers.
This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.
