Bond Prices and Interest Rates
Discuss the relationship between the price of a bond and interest rates. Why does the price of a bond change over its lifetime? Please offer a quantitative example to demonstrate this relationship.
The relationship between bonds and interest rates is inverse (Wells Fargo Asset Management, 2017). Changes in interest rates affect the bond values over time (Brigham, 2016). This inverse relationship indicates that when interest rates go up, then bond price goes down or that when interest rates go down, bond prices go up (Wells Fargo Asset Management, 2017). Normally, a bond’s interest rate or coupon rate is fixed, so any changes in market interest rates can affect the attractiveness of the bond (Wells Fargo Asset Management, 2017).
If a bond is purchased at $1000 with an interest rate of 7%, but interest rates go up to 10%, then to sell that bond, it would need to be sold at a discount to allow the 7% interest rated bond to equivocally result in the now 10% interest rate (Wells Fargo Asset Management, 2017). On the other hand, if interest rates fall, the $1000 bond with an interest rate of 7% could be sold for a premium because it has a higher interest rate than the market rate (Wells Fargo Asset Management, 2017).
Brigham, E. F. (2016). Financial management: Theory & practice, 15th Edition [VitalSource Bookshelf version]. Retrieved from https://bookshelf.vitalsource.com/books/9781305886…
Wells Fargo Asset Management (2017). The relationship between bonds and interest rates. Retrieved from https://www.wellsfargofunds.com/ind/investing-basi…
The Real World
In the real world, is it possible to construct a portfolio of stocks that has an expected return equal to the risk-free rate? Provide examples.
Hi Professor and class,
It is possible to construct a portfolio of stocks that have an expected return equal to the risk-free rate. These portfolios are called zero-beta portfolio. The only issue with this type of portfolio is that there is a low rate of return compared to higher beta portfolios which can make this portfolio look unappealing to investors (Investopedia, n.d.). Investors want portfolios that are diversified with market exposure. Short-term treasuries would be better and cost less than the zero-beta portfolio.
When measuring the worth of a portfolio, betas are used. If the beta is more than one, it means that the portfolio is more likely to change rapidly and unpredictably (Investopedia, n.d.). If the beta is less than one it means the opposite, the portfolio is less likely to change rapidly and unpredictably. There is also the possibility of a negative beta which means the investment goes the opposite way that investors want (Investopedia, n.d.). To create a zero-beta portfolio, multiple stocks and bonds are placed together in a way that causes the value to not fluctuate based on market movements or in other words eliminating systemic risk (Investing Answers, 2017).
An example would be that an investor has $5 million to invest. Say the investor places half the money into a Standard and Poor’s 500 index (S&P 500) mutual fund and the other half with any negative-beta bond fund (Van Domelen, 2015). This would systematically remove the risk associated with the mutual fund because it balances the risk out (Van Domelen, 2015).
Investing Answers (2017). Zero Beta Portfolio. Retrieved from http://www.investinganswers.com/financial-dictiona…
Investopedia (n.d.) Zero-Beta Portfolio. Retrieved from http://www.investopedia.com/terms/z/zero-betaportfolio.asp
Van Domelen, D. (2015). Towards a zero-beta stocks and bonds portfolio. Retrieved from https://seekingalpha.com/article/3653816-towards-z…