I wrote a post a few years ago about the relationship between bond prices and changing interest rates. If you are not familiar with this concept, it is worth reading before continuing with this post. However, if you understand why bond prices rise/fall when interest rates fall/rise, then you’re fine.
Modified duration is a measure of the expected change in the bond’s price for a given change in interest rates. However, this only really works for small changes at specific points on that bond’s particular price-yield curve. This is because the price-yield relationship is a curved relationship. It is convex.
But let me make it simple:
If interest rates were 10% and increased by 1%, that is a relative 10% increase in interest rates.
If interest rates were 1% and increased by 1%, that is a relative 100% increase in interest rates.
So we can see why bond prices are much more sensitive to interest rate changes in lower interest rate environments. Which we are in. We also expect interest rates to rise a few percentage points in the future.
So essentially, while many investors have flocked to fixed income looking for safety, they could be in store for a very rude awakening to how bond pricing works.
Great heads-up! This is a big reason why I’m currently holding cash instead of bonds for fixed income.
Preet…..I am holding PH&N inflation linked bond fund and noticed on the website it say’s the duration is 15 years, i think i am correct that for a 1% rise in rates a bond drops 1% for every year of duration, so if we see a 3% rise in interst rates i will drop 45%, i talked to my advisor and he say’s no this is not so with real return bonds so stick with the fund, i talked to PH&N and the rep said this is a higher risk fund that is not suitable for 90% of clients, could you comment please.
I am in my mid 50’s and have approx 70% equity based funds and stocks, 30% bonds & cash, all the bonds are hi yield, corporate or inflation link. Thank you…..Rick
Excellent write up that helps you understand some of those bond prices and rates equations. Convexity , huh? New word for me.