Bonds are a fundamental way to gain profits from both the interest that the bonds pay, and from the increases in the bond’s price. And though the bond market may go up and down, it’s not usually as dramatic as the changes in the stock market. Stone Oak wealth Management President and Wealth Advisor, Greg Thompson says, “If you’re considering investing in bonds, either directly or through mutual funds or exchange traded funds, it’s important to understand how bonds behave and what can affect your investment in them.”
Bond prices and yield can fluctuate just as the overall percentage rate of return on your investment can. Even though a typical bond’s coupon rate is fixed, the yield isn’t as it depends not only on a bond’s coupon rate, but also on any changes in its price. Even though both the bond prices and yields will go up and down, it’s important to remember that they move in opposite directions – when a bond’s price goes up, the yield goes down and vice versa.
That’s true not only for individual bonds but also for the bond market as a whole. When bond prices rise, yields in general fall, and vice versa.
What makes these ups and downs?
The main factors affecting a bond’s price is inflation and changing interest rates. Thompson adds “A change in either interest rates or the inflation rate will tend to cause bond prices to drop. Inflation and interest rates behave similarly to bond yields, moving in the opposite direction from bond prices.”
So, if inflation means higher prices, why do bond prices drop? Rising prices will reduce the purchasing power of each interest payment over time. This means that inflations will create a lower market because as inflation rises, the price of the bond drops due to a decreased demand for it.
Following are points of the inflation/interest rate cycle:
- When prices rise, bondholders worry that the interest they’re paid won’t buy as much
- The Federal Reserve may raise interest rates to encourage investors to purchase bonds in an effort to control inflation
- Borrowing costs rise when the interest rates go up, yet economic growth and spending tend to slow down.
- Inflation levels off or falls when less demand for goods and services come into play.
- Interest rates fall fueling economic growth and creating a potentially new inflation.
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Sources: Broadridge Investment Management Solutions
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