The inflation/interest rate cycle at a glance
- When prices rise, bondholders worry that
the interest they're paid
won't buy as much.
- To control inflation, the Fed may raise interest rates to get
investors to purchase bonds.
When interest rates go up, borrowing costs rise. Economic growth and spending tend to slow.
With less demand for goods and services, inflation
levels off or falls.
Bond investors worry less about the buying power of future interest payments. They may accept
lower interest rates on bonds, and prices of older
bonds with higher interest rates tend to rise.
Interest rates in general fall, fueling economic growth
and potentially new inflation.
In addition to being affected by monetary policy and economic events, a bond is subject to the risk of potential default by the issuer.
There is no assurance that working with a financial professional will improve investment results.
Bonds, Interest Rates, and the Impact of Inflation
There are two fundamental ways that you can profit from owning bonds:
from the interest that bonds pay, or from any increase in the bond's
price. Many people who invest in bonds because they want a steady stream
of income are surprised to learn that bond prices can fluctuate, just
as they do with any security traded in the secondary market. If you sell
a bond before its maturity date, you may get more than its face value;
you could also receive less if you must sell when bond prices are down.
The closer the bond is to its maturity date, the closer to its face value
the price is likely to be.
Though the ups and downs of the bond market are not usually as dramatic
as the movements of the stock market, they can still have a significant
impact on your overall return. If you're considering investing in bonds,
either directly or through a mutual fund or exchange-traded fund, it's
important to understand how bonds behave and what can affect your investment
The price-yield seesaw and interest rates
Just as a bond's price can fluctuate, so can its yield — its overall
percentage rate of return on your investment at any given time. A typical
bond's coupon rate — the annual interest rate it pays — is fixed. However,
the yield isn't, because the yield percentage depends not only on a bond's
coupon rate but also on changes in its price.
Both bond prices and yields go up and down, but there's an important
rule to remember about the relationship between the two: They move in
opposite directions, much like a seesaw. When a bond's price goes up,
its yield goes down, even though the coupon rate hasn't changed. The
opposite is true as well: When a bond's price drops, its yield goes up.
That's true not only for individual bonds but also for the bond market
as a whole. When bond prices rise, yields in general fall, and vice versa.
What moves the seesaw?
In some cases, a bond's price is affected by something that is unique
to its issuer — for example, a change in the bond's rating. However, other
factors have an impact on all bonds. The twin factors that affect a bond's
price are inflation and changing interest rates. A rise in either interest
rates or the inflation rate will tend to cause bond prices to drop. Inflation
and interest rates behave similarly to bond yields, moving in the opposite
direction from bond prices.
If inflation means higher prices, why do bond prices drop?
The answer has to do with the relative value of the interest that a
specific bond pays. Rising prices over time reduce the purchasing power
of each interest payment a bond makes. Let's say a five-year bond pays
$400 every six months. Inflation means that $400 will buy less five years
from now. When investors worry that a bond's yield won't keep up with
the rising costs of inflation, the price of the bond drops because there
is less investor demand for it.
Why watch the Fed?
Inflation also affects interest rates. If you've heard a news commentator
talk about the Federal Reserve Board raising or lowering interest rates,
you may not have paid much attention unless you were about to buy a house
or take out a loan. However, the Fed's decisions on interest rates can
also have an impact on the market value of your bonds.
The Fed takes an active role in trying to prevent inflation from spiraling
out of control. When the Fed gets concerned that the rate of inflation
is rising, it may decide to raise interest rates. Why? To try to slow
the economy by making it more expensive to borrow money. For example,
when interest rates on mortgages go up, fewer people can afford to buy
homes. That tends to dampen the housing market, which in turn can affect
When the Fed raises its target interest rate, other interest rates
and bond yields typically rise as well. That's because bond issuers must
pay a competitive interest rate to get people to buy their bonds. New
bonds paying higher interest rates mean existing bonds with lower rates
are less valuable. Prices of existing bonds fall.
That's why bond prices can drop even though the economy may be growing.
An overheated economy can lead to inflation, and investors begin to worry
that the Fed may have to raise interest rates, which would hurt bond
prices even though yields are higher.
Falling interest rates: good news, bad news
Just the opposite happens when interest rates are falling. When rates
are dropping, bonds issued today will typically pay a lower interest
rate than similar bonds issued when rates were higher. Those older bonds
with higher yields become more valuable to investors, who are willing
to pay a higher price to get that greater income stream. As a result,
prices for existing bonds with higher interest rates tend to rise.
Jane buys a newly issued 10-year corporate bond that has a
4% coupon rate — that is, its annual payments equal 4% of the bond's principal.
Three years later, she wants to sell the bond. However, interest rates
have risen; corporate bonds being issued now are paying interest rates
of 6%. As a result, investors won't pay Jane as much for her bond, because they could buy a newer bond that would pay them more interest. If interest
rates later begin to fall, the value of Jane's bond would rise again, especially
if interest rates fall below 4%.
When interest rates begin to drop, it's often because the Fed believes
the economy has begun to slow. That may or may not be good for bonds.
The good news: Bond prices may go up. However, a slowing economy also
increases the chance that some borrowers may default on their bonds.
Also, when interest rates fall, some bond issuers may redeem existing
debt and issue new bonds at a lower interest rate, just as you might
refinance a mortgage. If you plan to reinvest any of your bond income,
it may be a challenge to generate the same amount of income without adjusting
your investment strategy.
All bond investments are not alike
Inflation and interest rate changes don't affect all bonds equally.
Under normal conditions, short-term interest rates may feel the effects
of any Fed action almost immediately, but longer-term bonds likely will
see the greatest price changes.
Also, a bond mutual fund may be affected somewhat differently than
an individual bond. For example, a bond fund's manager may be able to
alter the fund's holdings to try to minimize the impact of rate changes. Your
financial professional may do something similar if you hold individual
Bond funds are subject to the same inflation, interest rate, and credit risks as their underlying bonds, and if interest rates rise and bond prices fall, that can adversely affect a bond fund's performance. Before purchasing a mutual fund, you should carefully consider its investment objective, risks, fees, and expenses, which can be found in the prospectus available from the fund. Read it carefully before investing.
Focus on your goals, not on interest rates alone
Though it's useful to understand generally how bond prices are influenced
by interest rates and inflation, it probably doesn't make sense to obsess
over what the Fed's next decision will be. Interest rate cycles tend
to occur over months and even years. Also, the relationship between interest
rates, inflation, and bond prices is complex, and can be affected by
factors other than the ones outlined here. Remember, investments seeking to achieve higher yields also involve a higher degree of risk.
Your bond investments need to be tailored to your individual financial
goals and take into account your other investments. A financial professional
may be able to help you design your portfolio to accommodate changing economic circumstances.