A reader writes in, asking:
“Do bond prices work like stock prices in that interest rate expectations are “priced in” in the same way that expectations for the company are “priced in” to the price of the stock? I guess what I’m asking is if everybody expects interest rates to rise and then they do rise, should I still expect my bonds to go down in value? Or does the change in interest rates have to be unexpected or bigger than expected in order for my bond prices to fall?”
As a bit of background for readers unfamiliar with the concept, a stock’s price at any given time reflects the market’s expectations for the underlying company. For example, if everybody expects a given company to have huge growth in profits over the foreseeable future, those expectations are built into the price of the stock. And the stock will only earn above average returns if the company’s profits turn out to be even greater than the market had expected.
In other words, the performance of a stock is not a function of how well the underlying company performs, but rather how well the company performs relative to the market’s expectations.
With regard to the reader’s question (i.e., whether it needs to be an unexpected change in interest rates in order to change bond prices), the answer is “it depends.” Specifically, it depends which interest rates we’re talking about.
A Bond’s Yield and Price Are Mathematically Linked
For typical nominal bonds, short of defaulting, there is no way for the interest rate to change without the price changing. A change in the price is how that the interest rate changes.
Example: If a bond with a $1,000 face value pays $40 of interest per year, that $40 is fixed. It doesn’t change. So the only way that the bond’s yield can be higher or lower than 4% is if the price is different from $1,000. In other words, the only way for the interest rate to change is for the price to change. Said yet another way, a change in the interest rate on this bond is literally the same thing as a change in its price (e.g., the bond price has gone up to $1,020 and now therefore has a yield of less than 4%, because you have to pay $1,020 to get that $40 of annual interest rather than just paying $1,000).
So if you own, for example, a 5-year Treasury bond and interest rates go up for 5-year Treasury bonds, the price of your bond will go down at the same time.
Expectations about Other Rates Might be “Priced in”
Bonds come with a variety of credit ratings and maturities, and there are different interest rates for each of those rating/maturity combinations. In addition, there are other interest rates that play important roles in the economy, such as the prime rate or the federal funds target rate.
And the interest rate on any given type of bond is based, to some extent, on expectations about various other interest rates (i.e., interest rates for other types of bonds or interest rates for things other than bonds). For example, bonds may at any given time be priced on the assumption that the Federal Reserve will raise the federal funds target rate by a certain amount. And therefore if the Fed does raise the rate by that amount, it won’t have much effect on bond prices, because that change was already “priced in.”