When a financial topic gets more press than the winter Olympics, we simply must talk about it.  Lately, not a day goes by where inflation and interest rates don’t make appearances on our news feed.  Stock markets fear inflation because higher input costs or borrowing rates may shrink corporate profits.  The bond market fears inflation because higher interest rates make existing bonds drop in value.  This correlation between bonds and interest rates is well-known but less understood.  Let us explain.  After all, it is trending.

Bond Basics

Think of a bond as an IOU from a corporation, municipality, or government. In exchange for your investment, you will receive interest (“coupon”) for a set period of time (“term”) until your investment is returned to you (“maturity”).

Interest Basics

In its attempt to control the supply of money, the U.S. Federal Reserve (the “Fed”) controls the Fed Funds Rate, which is the rate that determines all other rates, including the base rate for bond interest (known as the risk-free rate).  Decisions by the Fed to change rates act like a domino, pushing down or pulling up all other rates, accordingly.

The interest rate paid on a bond is also determined by risk.  The primary risk of bond investing is default risk – the risk that you don’t get paid back (interest and/or principal).  The greater the risk of default, the higher the coupon payment will have to be to get investors to buy a bond.

The Relationship

Put simply, bond prices go down when something better comes along.  Consider this: you buy a 5-year, 3% coupon bond for $1,000.  If interest rates rise a year after your purchase, your bond essentially becomes less desirable – both to you and to others.  In order to participate in the now higher-paying bond options, you could sell your 3% bond to buy, say, a 4% bond instead, but to entice a buyer to choose your 3% bond over the 4% he or she could get elsewhere, you will need to reduce the price of your bond.  Remember, you stood to receive 3% per year from the bond, plus $1,000 at maturity. In this example, a buyer would be willing to pay about $963 for your bond, which would provide the 4% return he or she is expecting (3% coupon plus the difference between $963 and $1,000).  Note that this loss in value would only occur if you chose to sell your bond.  If you don’t sell (and assuming no default), you should plan to recoup the full $1,000 upon maturity.  This is a key concept in bond investing; interim price fluctuations are virtually immaterial unless you plan to sell.

Since a lot can happen over longer periods of time, the risk of something better coming along is greater with longer-term bonds. Accordingly, the longer a bond’s maturity, the more sensitive its price will be to changes in interest rates.