In a rising interest rate environment, how would bond values change over time? As a bond investor, what measures would you take to manage rate risk?
In a rising interest rate environment, bond prices would go down. The reason is that investors can now achieve a higher yield than what was previously accessible. This will result in current yields for bonds selling at par to be inadequate relative to higher yield bonds. To compensate for this, the bonds will fall in price so that the yields match those that are prevailing in the market. The opposite will occur when interest rates fall. In fact, this is exactly what has occurred in the market as investors have benefited from a near 2-decade bond bull market where interest rates have fallen and bond investors have profited.
To manage risk, bond investors should have a portfolio that has a shorter duration. That way, they can reduce the risk associated with long term bonds declining. A short duration bond portfolio allows the investor to take his principle and use it to purchase bonds that are higher yielding in the event that interest do rise as he or she projects. Derivatives also can help with this as well. Interest Rate Swaps for example can help an investor lock in an interest or hedge against a decline in his or her bond holdings. This will also help to mitigated the risk of sudden and unforeseen changes in interest rates.
References
1. Amiram, D., A. Kalay, A. Kalay and N. B. Ozel. 2018. Information asymmetry and the bond coupon choice. The Accounting Review (March): 37-59
