Changing Interest Rates – Spring 2005

Hello from Sycamore,

Corporate Bonds and Changing Interest Rates

Many of you own corporate bonds and recently, after receiving your monthly statements, a few of you have called to see what’s wrong with you your “fixed” investments. Sooo….we thought this may be a good time to review how most corporate bonds work and discuss how future interest rate changes may effect your bond investments in the future.

Generally speaking, bonds and other fixed rate investments guarantee the interest that you will receive and the return of your principal at some future date known as “the maturity date”. This means that if you invest $1,000 into a $1,000 bond that pays 3% interest and matures in three years, you will earn $30 per year in interest ($90 total). When the three years have passed the entity guaranteeing the return of your principal will pay to you the original $1,000 that you invested. It’s important to note here that the guarantee of the return of your investment is only as good as the entity that is making the guarantee. During the time between your purchase and the maturity date, the market value of your investment can, and most likely will, fluctuate.

Here’s an example of how that may work and why. Let’s suppose that interest rates were at 3% when you bought the above hypothetical bond. Then, during the next year, interest rates rose to 4%. Compared to the current interest rate of 4% your investment (which is still earning 3% because the interest rate is guaranteed) looks a bit puney. Because another investor buying a bond today knows that they can receive 4% by purchasing other bonds, they will not want to pay you the full maturity value ($1,000) for your bond because it pays less interest (3%). So, in our hypothetical, if you decided to sell your investment after holding it one year instead of keeping it untill the maturity date, (something that you can do with most fixed investments) you would be forced to reduce the sale price to a level that would allow the new buyer to attain a yield of 4% on their investment.

All bond purchase or sale transactions are published, so at the time that you buy or sell, your transaction would determine the current market price of your 3% bond. If your sale had taken place at a price of $850 for example, then all other investors who hold this same 3% bond would see their bond valued at $850 also. This would give them a good idea of the amount that they would receive today if they would sell their bond, but have virtuall no effect on them if they are going to keep their bond until maturity. Remember, at the maturity date, investors get the full $1,000 principal amount returned, regardless of current interest rates.

So how does this affect you? If you own bonds, or other fixed interest rate investments, in todays rising interest rate environment, your monthly statements will likely show a decline in the market value of your investments. Remember, this market value is important only if you are actually going to sell your investment prior to the maturity date. If you intend to keep your bonds untill the final maturity date, this “current market valuation” is simply FYI and when the final maturity date arrives you will realize the rate of return that you locked in when you originally purchased your bond.

If interest rates continue to rise (we think that is likely in the near future) your “market values” will probably decline some more. If interest rates reverse direction and start to decline, then you will see your “market values” begin to rise. Generally speaking, bonds with longer maturity dates will fluctuate more that shorter term bonds. Because of this and our current rising interest rate enviroment, we have been recommending that investors purchase bonds that have short (three to five years) maturity dates. Also, since your principal return is guaranteed by the company that you are investing in, we recommend that you buy only “investment quality” bonds.

We realize that these concepts are somewhat confusing, so if you have questions or would like more information give us a call or drop an e-mail.

Thanks for your business and trust,

Sycamore Financial Group