by Archie M. Richards, Jr., CFP^®
March 28, 2005

Why do bond prices move opposite to interest rates? Here are the basics of bond investments:

A bond is an IOU of $1,000 issued by a government or corporation in return for borrowing money for an extended period. The $1,000 is called the "par value."

The bond certificate specifies when the $1,000 will be repaid. That's the "maturity."

The dollar amounts of interest remain constant, usually paid semi-annually.

Bonds are traded among investors at prices the buyers and sellers agree to.

Here's why bond prices move opposite to interest rates: The dollar payments of interest, as mentioned, remain the same. When interest rates in the economy rise, the interest payments on older bonds, which remain unchanged, become less desirable. Therefore, the prices fall.

Let's say you buy $10,000 of Treasury bonds at par (meaning you pay $10,000). The bonds mature in 25 years. At the time of your purchase, interest rates on 25-year bonds are 5 percent. Your bonds pay interest of $500 a year. At maturity, 25 years hence, the bonds will pay $10,000.

Ten years pass. Your bonds now have 15 years left. All along, you've received payments of $500 a year.

But interest rates in the economy have risen. $10,000 of new Treasury bonds due in 15 years now pay 7 percent - $700 a year.

You want to sell your bonds. A potential buyer says, "I can buy new 15-year bonds for $10,000 that pay $700 a year. Why should I pay you $10,000 for bonds of the same maturity that pay interest of only $500?"

Sorry, you have to sell your bonds for only $8,178.

The buyer comes out fine. She receives $500 a year. In 15 years, the bond pays off at $10,000. The profit at maturity ($10,000 less her cost of $8,178) raises the overall yield-to-maturity to 7 percent.

But you're left holding the bag.

Rising interest rates are bad news for bond holders. The longer the maturity, the greater the percentage loss. If a bond is due tomorrow, any change in interest rates during the final 24 hours has no effect, because the bond pays off so soon. But if a bond is due in 20 years, the maturity value so far in the future has little current impact. Interest-rate changes therefore influence the price a lot.

Now for the taxation of bond interest:

• Interest payments on corporate bonds are taxed by both the IRS and by state governments.

• Interest payments on federal bonds are taxed by the IRS but not by the states.

• Interest payments on municipal and state bonds are not taxed by the IRS. But they are taxed by the states (although usually not by the state from which the bond was issued).

  Despite the tax advantage, there are two reasons to be wary of municipal bonds.

• The interest is lower than that of taxable bonds.

• Most municipal bonds are callable after ten years. The state or municipality that issued the bonds can buy them back before maturity, usually at 2 percent above par ($1,020 per bond).

Let's say you buy $10,000 of municipal bonds maturing in 25 years, paying interest of $500 a year.

Ten years pass. The bonds have 15 years to go. Interest rates on 15-year municipal bonds have fallen from 5 percent to 3 percent. Without a call feature, your bonds would be worth $12,388.

The municipality takes advantage of the lower rates by issuing another set of bonds that pay only 3 percent and uses the proceeds to buy back your bonds. The price it pays you is 2 percent above par ($10,200). Your bonds are not worth $12,388 after all; they're worth only $10,200.

If interest rates move up from 5 percent to 7 percent, your bonds would be worth only $8,178, for a loss of almost $2,000. The municipality wouldn't call your bonds then. It would let you suffer the loss.

To summarize, if interest rates fall, the municipality calls the bond, to your disadvantage. If interest rates rise, the municipality does not call the bond, also to your disadvantage. Heads, the municipal wins. Tails, you lose.

Bonds are appropriate as investments. But stick to the non-callable variety.