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Author: rkmacdonald Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35400  
Subject: Re: Why should bond prices drop? Date: 1/10/2005 11:25 AM
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Author: TravisJ2002 | Date: 1/9/05 7:09 PM | Number: 11575
I'm relatively new to understanding bonds, but I understand that as rates go up, prices for outstanding bonds should go down, in general. It seems almost assured that as the fed raises interest rates, government bonds should go down in price, in general.

However, given that we expect the fed to raise interest rates, and that the fed is doing it in a fairly predictable manner, shouldn't the bond price remain the same? One usually true principle in stocks is that if everyone knows the price will go down (or up) tomorrow, then it will go down (or up) today. Why shouldn't that be true with bonds? Wouldn't reasonably expected interest rate increases already be priced into bonds?

Or is there something I'm missing.


Well, one thing you may have missed is that the sensitivity of a bond to interest rates is measured by what is called 'duration'. You can calculate the duration for any individual bond or for a bond fund, in which case it is called 'average duration'. If the duration of a bond is 4 years, that means that it is 4 times as sensitive as interest rates. In other words, if rates move up 1%, the value of the bond will move down approximately 4% in value. You can look up the average duration of a bond fund on Morningstar or the fund's own website. You have to calculate the duration of an individual bond yourself.

I bolded 'approximately', because the other effect on value of a bond is market semand just as you pointed out. But, the effect that the market demand has on bond values is actually quite small and temporary. The market effect on stock proces is orders of magnitude higher than for bonds. This is one of the main reasons that bonds are far safer (in terms of standard deviation; ie, volatility) than stocks.

You also need to understand that 'average duration' is not the same thing as 'average maturity'. Average duration has no pratical meaning other than to indicate the sensitivity to interest rates, while average maturity indicates the average time inside a bond fund for each bond to mature and recover its par value. Then the proceeds are used to buy a new bond or pay dividends. Many people wrongly equate average duration and average maturity'. They are totally different.

Russ
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