Higher Rates Will Pressure Bond Prices
Interest rates have an inverse relationship with bond prices. The way bond prices are calculated can be a little awkward. However, even if you have not purchased a single bond for your portfolio, it’s still good to understand how they work and how their prices are calculated.
Why Bond Prices Change With Interest Rates?
When interest rates rise, bond prices fall. When interest rates go lower, bond prices increase. It is really that easy to understand the basic concept and inverse relationship.
So, why is it that if interest rates rise, bond prices fall and when interest rates fall, bond prices rise? This is because when interest rates rise, investors can get a better rate of return elsewhere, so the price of original bonds adjust downward to yield at the current rate. Think of it as an adjustment to changes in interest rates.
Bond vs. Stock
Unlike stocks where you own a piece of the company, bonds are a type of loan made by an investor, so you own some of the debt the company owes. Many times, the loan is to a company or government agency. In return, the investor receives fixed-rate interest income, which remains the same despite how market interest rates might change.
So, if the interest rate is fixed, you can see how the bond price would adjust with changes in the interest rates.
Bonds compete against one another on the interest income they provide to the end investor. When interest rates go up, there are new issue bonds coming out with a higher rate which provides more income. On the other hand, when interest rates go down, new bonds issued have a lower rate and aren’t as tempting as older existing bonds.
As a result, the only way to increase competitiveness and attract new investors is to reduce the bond’s price to adjust to the market. As a result, the original bondholder has an asset that is worth less than originally paid for. Also, It does not pay out as much as the new issue bonds coming on the market.
Buy Bonds When Rates Start Rising?
Interest rates will always change, and no one can predict how they’ll change over extended time periods. Bond pricing can be complex, so make sure you understand what you are buying and what you are receiving in return or, better yet, consider working with a financial advisor.
They can help you run the numbers and figure out whether a bond purchase is a fit for your goals.
Bonds can be an important part of an overall portfolio. It always helps to know how interest rates affect their prices so that you can adjust your portfolio or holdings when rates change. This information is for educational purposes only and is in no way tax, investment, or financial advice. Investing involves risk including the possible loss of principal.
Submitted By Mike Amos
Founder and Active Contributor of millionairemindset.life