Understanding the Relationship between Interest Rates and Bonds
For most people, investing in stocks makes a certain amount of intuitive sense – when a company makes more money, the stock becomes more valuable, and the price goes up. Bonds, not so much. Despite being a key part of nearly every investor’s retirement portfolio, bonds can remain a mystery to most.
But before we dive into what exactly makes the price of a bond go up or down, first we need to understand exactly what a bond is. In short, when you buy a new bond, you are essentially lending money to the issuer (usually a corporation or government) in exchange for periodic interest payments and the return of the bond's face value (ie: the amount you originally paid for it) at maturity. The interest rate, or yield, of a bond is a key factor in determining its appeal to investors. In the US, these interest rates are predominantly influenced by the Federal Reserve.
This is where the seesaw comes in. When the Federal Reserve raises interest rates, newly issued bonds come with a higher yield, making them more attractive to investors (why would I buy your old 3% bond when I could buy a new 4% bond with the same face value instead!). This means existing bonds - which were issued with a lower yield - become less desirable in comparison. To remain competitive, these older bonds must decrease in price until their effective yield matches the new, higher interest rates. In other words, when the interest rate side of the seesaw goes up, the price of your existing bond goes down.
And as you might have guessed, the exact opposite occurs when interest rates fall. Existing bonds with higher yields become more attractive when compared to new bonds with lower yields. The interest rate goes down, the price of your old bond goes up.
Average Interest Rate on a 30 Year Fixed Mortgage
January 1982 - August 2023
As you can imagine, this dynamic relationship between interest rates and bonds plays a critical role in how we think about positioning our clients for their financial futures. And that positioning has never been more important than it is now. For nearly 40 years this seesaw has been almost entirely one-sided, with interest rates trending steadily downward since 1982. Now, in just 18 months, interest rates are back to levels we haven’t seen since 2001. But while big shifts like these can be jarring, they also represent big opportunities for investors who understand the ins and outs of these key market relationships. As your advisors, we are constantly leveraging our understanding to seize these opportunities on your behalf.
Investing involves risk. No investment strategy can guarantee positive results. Loss, including loss of principal, may occur. Material discussed is meant to provide general information and it is not to be construed as specific investment, tax or legal advice. Keep in mind that current and historical facts may not be indicative of future results. Diversification is an investment strategy that can help manage risk within a portfolio, but it does not guarantee profits or protect against loss in declining markets.
This content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. (C) Twenty Over Ten