Question

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?

Answer 1

When interest rate rises price of the bonds decreases. This is due to the discounting rates used to evaluate the price of the bond. Consider an example. Suppose the non coupon bond has 1 year to maturity and 5 percent is used to discount the bond, the price of bond becomes 100/1.05=95.23. now interest rate has gone up by 2 percent so new discounting value is 7%. The new price of bond becomes 100/1.07=93.45.

Longer the duration of bond longer is its senstivity towards interest rate risk.

As a bond investor following measures can be taken to manage rate risk:

1) own short duration bonds because longer the duration of bonds longer is the interest rate risk present in the bond.

2)Hold the bond till maturity so as to avoid price fluctuations due to interest rate changes. Bonds at maturity are payable at par.

3)buy non callable bonds. This reduces the risk of bond being called when interest rate reduces.