I was reading this article in the Motley Fool about Silicon Valley Bank’s closure and in this paragraph was a bunch of terms that I couldn’t wrap my head around. But the thing that got me was: “bond values go down when interest rates go up.”
Can someone explain *why* bond values go down when interest goes up? And what crash course on economics I should take to get a handle on all this?
Excerpt from article:
>”This is where Silicon Valley Bank went wrong. It bought too many higher-yielding held-to-maturity (HTM) assets that were meant to be — as their classification suggests — held until they mature; this maturity could be as much 30 years into the future. The over-commitment to the wrong long-term assets subsequently prevented the bank from buying enough shorter-term, available-for-sale (AFS) bonds and debt instruments that (if necessary) could have been sold to fund customer withdrawals. Less than one-fourth of SVB’s securities backing customer deposits were of the available-for-sale variety, in fact. Aggravating the misstep was the purchase of fixed-income instruments that proved overly sensitive to rate hikes. Remember, bond values go down when interest rates go up.
>
>It was this unhealthy mix of assets that would eventually deal the death blow.”
In: 8
When interest rates go up, there’s less demand for bonds. That lack of demand drives down values. Banks also need to have money available to meet withdrawals when they’re made, which you can’t do with bonds that must be held until maturity.
[deleted]
The *final* value of a bond is fixed. That’s what is causing the behavior you are talking about. When the rate of return is higher, the *current value* has to be lower in order to get to the same final value.
[deleted]
Let’s say I buy a $1000 bond paying 3% interest last year. Now, rates for newly issued bonds are 6%.
Why would anybody buy my 3% bond for face value if they can buy a newly issued one that pays 6%?
So if I want to sell, I would need to lower the price I am willing to get such that the purchase price makes the effective interest payment 6% instead of 3%. If I sell for $500, then the effective interest rate would be 6% instead of 3%. (In actuality, the new sale price is more complex because there is still the repayment of the full principal at the end to factor in, but example is for ELI5 purposes).
The *final* value of a bond is fixed. That’s what is causing the behavior you are talking about. When the rate of return is higher, the *current value* has to be lower in order to get to the same final value.
When interest rates go up, there’s less demand for bonds. That lack of demand drives down values. Banks also need to have money available to meet withdrawals when they’re made, which you can’t do with bonds that must be held until maturity.
Lets say you have $1000 spare that you do not need now but need in ten years. So you go to the government and buy a $1000 bond that matures in 10 years with a 0.5% yearly interest. So in ten years you can take the bond to the government and get your $1000 back and an additional $50. Not much but at least your money is safe and gives some yield.
But now consider that right after you bought your bond the interest rates goes up to 1%. And it turns out that you actually needed those $1000 anyway. You can not go to the government to cash in your bond just yet, you need to wait ten years. So you go to an open market and offers to sell your bond to the highest bidder. The only problem you have is that the government is still issuing bonds but now at 1%. So if someone buys a bond from the government they will get an additional $100 in ten years instead of the $50 your bond yields. So nobody is willing to buy your bond for the full face value as the bonds the government issues yields more. You therefore end up having to sell your $1000 bond for only $950. You essentially lost $50 because the interest rate went up by 0.5%
Let’s say I buy a $1000 bond paying 3% interest last year. Now, rates for newly issued bonds are 6%.
Why would anybody buy my 3% bond for face value if they can buy a newly issued one that pays 6%?
So if I want to sell, I would need to lower the price I am willing to get such that the purchase price makes the effective interest payment 6% instead of 3%. If I sell for $500, then the effective interest rate would be 6% instead of 3%. (In actuality, the new sale price is more complex because there is still the repayment of the full principal at the end to factor in, but example is for ELI5 purposes).
Just to clarify, bond value here means bond price and not the “intrinsic or inherent value of a bond”
Latest Answers