Bonds, Interest Rates, and Inflation (2024)

LaurieHaelen, AIF®
Senior Vice President, Director of Wealth Solutions
[emailprotected]
(585) 419-0670 x41970

2022 has certainly been an interesting and somewhat stressfulyear for investors, with high inflation and market volatilitydominating the financial news daily. During all of this, evenbonds—historically less risky than stocks—have decreasedin value year to date. To understand why, you must firstunderstand the nature of bonds and why interest rates andinflation can impact the prices.

There are two fundamental ways that you can profit fromowning bonds: from the interest that bonds pay, and from anyincrease in the bond's price. Many people who invest in bondsbecause they want a steady stream of income are surprised tolearn that bond prices can fluctuate, just as they do with anysecurity traded in the secondary market.

Just as a bond's price can fluctuate, so can its yield—its overallpercentage rate of return on your investment at any giventime. A typical bond's coupon rate—the annual interest rateit pays—is fixed. However, the yield isn't, because the yieldpercentage depends not only on a bond's coupon rate but alsoon changes in its price.

Both bond prices and yields go up and down, but there's animportant rule to remember about the relationship betweenthe two: They move in opposite directions, much like a seesaw.When a bond's price goes up, its yield goes down, even thoughthe coupon rate hasn't changed. The opposite is true as well:When a bond's price drops, its yield goes up. That's true notonly for individual bonds but also for the bond market as awhole. When bond prices rise, yields in general fall, and viceversa.

In some cases, a bond's price is affected by something thatis unique to its issuer—for example, a change in the bond'srating. However, other factors have an impact on all bonds.The twin factors that mainly affect a bond's price are inflationand changing interest rates. A rise in either interest rates or theinflation rate will tend to cause bond prices to drop. Inflationand interest rates behave similarly to bond yields, moving inthe opposite direction from bond prices.

The reason has to do with the relative value of the interestthat a specific bond pays. Rising prices over time reduce thepurchasing power of each interest payment a bond makes.Let's say a five-year bond pays $400 every six months. Inflationmeans that $400 will buy less five years from now. Wheninvestors worry that a bond's yield won't keep up with therising costs of inflation, the price of the bond drops becausethere is less investor demand for it.

Inflation also affects interest rates. This year has certainly beenone where there is a lot of talk about the Federal Reserve Boardtrying to tame inflation by raising interest rates. However, theFed's decisions on interest rates can also have an impact onthe market value of your bonds. The Fed takes an active role intrying to prevent inflation from spiraling out of control. Whenthe Fed gets concerned that the rate of inflation is rising, likethis year, it may decide to raise interest rates which in turn canaffect the economy.

When the Fed raises its target interest rate, other interest ratesand bond yields typically rise as well. That's because bondissuers must pay a competitive interest rate to get peopleto buy their bonds. New bonds paying higher interest ratesmean existing bonds with lower rates are less valuable. Pricesof existing bonds fall. That's why bond prices can drop eventhough the economy may be growing. An overheated economycan lead to inflation, as we have seen this year, and investorsbegin to worry that the Fed may have to raise interest rates.Bond prices would be negatively impacted, while the yields(or income) on bonds would increase.

Just the opposite happens when interest rates are falling.When rates are dropping, bonds issued today will typicallypay a lower interest rate than similar bonds issued when rateswere higher. Those older bonds with higher yields becomemore valuable to investors, who are willing to pay a higherprice to get that greater income stream. As a result, prices forexisting bonds with higher interest rates tend to rise.

Bonds are an important asset class to have in an investor’sportfolio. Though the ups and downs of the bond market arenot usually as dramatic as the movements of the stock market,they can still have a significant impact on your overall return.If you're considering investing in bonds, either directly orthrough a mutual fund or exchange-traded fund, it's importantto understand how bonds behave and what can affect yourinvestment in them.

Your bond investments need to be tailored to your individualfinancial goals and integrate with your other investments.Our team at CNB Wealth Management may be able to helpyou design your financial plan to accommodate changingeconomic circ*mstances.

©2022 Broadridge Investor Communication Solutions, Inc. All rights reserved. This material provided by Laurie Haelen.