Buying Treasuries?
First You Need to Know About Interest Rate Risk
Investing in US Treasuries has historically paid very little but things are different today with the 1-Year T-Bill paying a healthy 5.40% — not bad! You may have heard that this return is “risk-free,” which is mostly true. However, there are two types of risk to consider when investing in bonds — credit risk and interest rate risk. Credit risk is the risk that a borrower will be unable to pay their obligations at maturity. Unless you think the United States government will go bankrupt, Treasuries have no credit risk. Treasuries do however have interest rate risk — the risk that rates may increase before a bond’s maturity causing its price to fall. In this post I will explain the intuition behind the concept of duration, which is finance speak for how sensitive a bond is to the level of interest rates.
The relation between bond prices and interest rates is that bond prices go down when interest rates go up, and vice versa. Many outside of the finance world could benefit from a better understanding of this relationship, so let’s look at a simplified example to help make the concept concrete. Imagine you purchased a treasury bond with a 5-year maturity some time in early 2020 (near where the grey bar is):
The yield at that time was anywhere between 0.2% and 1.6%, with rates steadily decreasing beginning in February as the government provided unprecedented stimulus due to COVID-19. For this example, let’s assume you bought in when rates were about 1.0%. You have now locked up your money for five years and will receive 1.0% annually until maturity when you get your money back. If you invested $100, you’ll receive $1 each year and $100 at maturity in year five, for a total of $105. However, if you need the cash earlier, you also have the option to sell your bond before maturity, just like you can sell a stock. This is where interest rate risk comes in.
It is now March 2023, three years later, and you’ve decided that you need that $100 back. You’ve collected $3 in interest so far but you really need the $100 principal back so you can finally build that pool you promised your kids. Two years remain for your bond to mature, so you decide to sell it rather than wait and disappoint little Johnny and Jenny. After logging into your brokerage you notice that your $100 bond is now only worth $92. This means you would actually lose money, even after adding the $3 of interest you collected over the prior three years. You spent $100 and received $95 in total. So much for “risk-free”!
Why did this happen? To understand, let’s have a look at where interest rates for 2-year bonds (the amount of time left on your original 5-year bond) were in March 2023:
The 2-year bond pays 5.05%, whereas your bond pays 1.0%. This means anybody considering buying your bond would receive 4.05% less than they could receive by purchasing the new 2-year bond. Why would anybody do that? They wouldn’t unless they could buy it cheaper than the full price of $100, e.g. at a “discount”, which is exactly why your bond is now at $92.
Each of the next two years, the purchaser will still receive the $1 coupon, but they will additionally receive the full $100 face value upon maturity having only spent $92. How much did they receive in total? Two $1 coupons and $100 at maturity. How much did they spend? — $92. They made $102 and spent $92 for a net gain of $10.
What if they had instead purchased the new 2-year bond, which pays a coupon of 5.0%? They would have paid full price ($100 e.g., par) and received two $5 coupons yearly over the next two years. At maturity, they will receive the par value ($100) for a net gain of … also $10, the same as the discount bond above.
This simple example ignores some of the finer details around the time value of money and a few other nuances. Still, it is meant to provide an intuitive explanation of how interest rates impact bond prices. If you buy a bond and rates subsequently increase, the value of your bond will decline to match the market rate. All else equal, bonds with a longer maturity and lower coupon are more sensitive to interest rates — or in finance terms, they have “greater duration.” At the extreme, imagine buying a 30-year bond with a 1.0% coupon, and rates go up the next year to 4%. Any purchaser of the “old” bond would only receive 1% for the 29 remaining years when they could be receiving 4% instead. That means they would pay far less for your bond to make the yields equivalent — in this case about 49 cents on the dollar! The inverse is also true — if you buy a bond and rates go down, your price moves up.
Lastly, it is important to understand that if you hold your investment until maturity, price fluctuations caused by changes in interest rates do not impact you. In the example above, if you held on to your bond instead of selling for $92, you would still have received $100 at maturity in 2 years and earned $105 in total (5 coupon payments of $1 each plus the $100 initial investment). This is why it’s critical to understand your financial needs and avoid putting yourself in the position of being forced to sell early, potentially at a loss. If you need access to your funds before the maturity date of a bond you are considering investing in, purchase a shorter-dated bond or put the money in a savings account.
If you’re curious to read about how interest rate risk played a part in one of the largest bank failures in history, check my article One to Zero.