Interest rates have been on the low side recently. But what goes down must come up, so you can expect this trend will eventually be reversed and interest rates will begin to climb again. If you’re wondering how these developments affect bonds you already own, it’s a good question. Even experienced investors can find it a challenge to grasp how bond markets really work. However, there is logic behind the ups and downs.
Bond Basics. Put simply, a bond is an IOU. Governments and businesses issue bonds to raise cash for various purposes. The markets use several descriptors to identify a bond: the issuer’s name, the bond’s face (or par) value, the rate of interest paid to the bondholder, and the maturity date (on which the issuer repays the principal). Because bonds trade on the open market, their prices fluctuate—and that is where things can get complicated.
How Interest Rates Affect Bond Prices. While many factors may push the price of a bond above or below its face value, perhaps the most direct impact comes from changes in interest rates. As interest rates rise—or threaten to rise—bond prices tend to fall, and vice versa.
Imagine you own a bond that pays 5% interest. After a Federal Reserve rate hike, newly-issued bonds offer a 6% rate. To someone in the market for bonds, the new rate seems much better. Lower demand for the 5% bond translates into lower prices. Conversely, if the prevailing rate falls to 4%, your bond suddenly becomes more attractive, and should command a higher price. (Note, these figures are hypothetical.)
Price vs. Yield. However, markets generally refer to bond values not by price, but by yield—the annual interest divided by the current price. If your 5% bond has a face value of $10,000, you receive $500 a year in interest. If the bond sells “at par”—the face value—the yield would be 5% ($500 divided by $10,000). But if the bond’s price dips to $8,000, the yield would be 6.25% ($500 divided by $8,000).
Therefore, as price falls, yield rises, and vice versa. Think of it this way: if you buy a $10,000 bond at $8,000, your investment will “yield” more, in the form of interest payments that, in percentage terms, reflect a better return on your investment. (That’s known as current yield. Another measure, yield to maturity, gauges the total return you would receive by holding the bond to maturity.)
So, once again:
As interest rates rise—or threaten to rise—bond prices tend to fall, and vice versa.
As prices fall, yields rise, and vice versa.
As interest rates rise—or threaten to rise—bond yields tend to rise, and vice versa.
These movements bring the yields of existing bonds into line with those of new issues.
Exploring the Yield Curve. To understand this concept, start with the fact that long-term bonds tend to have higher yields than short- or intermediate-term bonds. That’s because long-term bonds carry more risk—more can happen to affect the price during the longer term of the bond—and investors expect a higher yield for assuming extra risk.
The yield curve plots the current yields of bonds of various maturities on a graph. A normal curve shows a rise in yields as terms get longer. With a steep curve, long-term yields are substantially higher than short-term yields, while a flat curve shows short- and long-term yields that are more or less equal. An inverted curve happens when short-term yields are higher than long-term yields.
The yield curve is important because it may reflect investor sentiment or expectations. For instance, a steep curve indicates investors are bidding up the price (and therefore driving down the yield) of short-term rates. That could mean they expect interest rates to rise. They want to hold short-term bonds that will mature quickly, so they can reinvest at a higher rate.
What About Inflation? Why does the bond market often fall on good economic news? The fear is that strong economic growth could trigger inflation—which means bond investors would be repaid (both principal and interest) in cheaper dollars. Positive economic news can also lead investors toward stocks and away from bonds, which are often considered “safer” investments to turn to when times are tough.
In reality, of course, all markets are far more complex than this, and unusual market movements can confound even the most sophisticated analysts. Still, a little logic can make “Inflation fears send bond yields higher” a little easier to understand.
This article was written by a professional financial journalist for Forbes Financial Planning, Inc and is not intended as legal or investment advice.