Inflation and Bonds: The Ups and Downs

The price/rate seesaw

Inflation has an impact on most securities, but it can particularly affect the value of your bonds. Why? Because bond yields are closely tied to interest rates, and when interest rates and bond yields rise, bond prices fall.

When the Federal Reserve Board gets concerned that the rate of inflation is rising, it may decide to raise its target interest rate. That makes borrowing money more expensive, which in turn tends to slow the economy. When the Fed raises its rate, bond yields typically rise as well. That’s because bond issuers must pay a competitive interest rate to get people to buy their bonds.

When yields rise, bond prices fall. That’s why bond prices can drop even though the economy may be growing. An overheated economy can lead to inflation, and investors often begin to worry that the Fed will raise interest rates, which would hurt bond prices.

Falling rates: good news, bad news

Just the opposite occurs when interest rates are falling; bonds issued today will typically pay a lower interest rate than similar bonds that were issued when rates were higher. Older bonds with better yields become more valuable to investors, who will pay a higher price to get that greater income stream. As a result, prices for those higher-yield bonds tend to rise.

Example:   Jane buys a newly issued 10-year corporate bond that has a 4% coupon rate–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 as much for Jane’s bond, since they could buy a new one that pays more interest. If rates fall later, Jane’s bond would rise in value.

When interest rates drop, bond prices tend to go up. However, a slowing economy increases the chance that some borrowers may default on their bonds. Also, when interest rates fall, some borrowers may redeem existing bonds and issue new ones at a lower interest rate, just as you might refinance a mortgage. If you plan to reinvest any of your bond interest, it may be a challenge to generate the same 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 reflect the effects of any Fed action most immediately, but longer-term bonds likely will see the greatest price changes.

Also, a portfolio of bonds may be affected somewhat differently than an individual bond. For example, a portfolio manager may be able to minimize the impact of rate changes, altering the portfolio’s duration by adjusting the mix of long-term and short-term bonds.

Focus on goals, not just rates

Your bond investments need to be tailored to your financial goals, and take into account your other investments. Your financial professional can help you design a portfolio that can accommodate changing economic circumstances.

The inflation/interest rate cycle at a glance

·       Inflation goes up

·       Bondholders worry that the interest they’re paid won’t buy as much in the future because inflation is driving costs higher.

·       The Fed may decide to raise interest rates to try to control inflation. To get investors to lend money (buy bonds), bond issuers must pay higher interest rates.

·       When interest rates go up, bond prices go down.

·       Higher interest rates make borrowing money more expensive. Economic growth tends to slow, which means less spending.

·       With less demand for goods and services, inflation levels off or falls.

·       With lower inflation, bond investors are less worried about the future purchasing power of the interest they receive. Therefore, 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 a new round of inflation.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2015.