The Relationship Between Bond Prices and Interest Rates
While bonds provide an element of stability for an investor’s portfolio, they are vulnerable to economic changes that can decrease their value. In fact, the biggest threat to bond prices is rising interest rates. Interest rates constantly go higher and lower with their direction determined by a number of factors, including decisions by the Federal Reserve (“The Fed”), inflation, currency exchange rates and the overall health of the economy.
The Basics of Bond Investing
Bonds are issued by companies and by government agencies on all levels (federal, state, and local) to finance projects or to simply fund their daily operations. Bond purchases provide loans to these organizations for a specified period of time. Bond investors receive interest payments during the life of the bond and the full amount of the initial investment at the end of the loan- the bond’s maturity. Because bonds typically offer a predicatable stream of income, along with the repayment of the initial investment, many financial advisors recommend that investors include bonds as part of a diversified portfolio.
The Inverse Relationship between Interest Rates and Bond Prices
When you look at previously issued bonds that are trading on the open market, it is important to recognize the inverse relationship of bond prices and interest rates- as interest rates rise, bond prices fall and as interest rates fall, bond prices rise.
To illustrate the rationale behind this, let’s says that you have a $10,000 bond that pays a 5% interest rate. If interest rates rise to 6%, you need to drop the price of your bond (sell it at a “discount”) somewhere below $10,000 to make the return comparable to the new, higher interest rate an investor can receive elsewhere. If interest rates were to decrease, you could sell your bond at a “premium” (somewhere above the $10,000 price) to make the return comparable to current rates.
Regardless of how interest rates affect bond prices, many financial advisors remind investors that investing is usually done as a long-term strategy and that it might be in their best interest to ride out these interest rate changes, keeping the larger picture in mind.
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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