Bonds, Interest Rates, and the Impact of Inflation

Bonds, interest rates and inflationThere are two fundamental ways that you can profit from owning bonds: from the interest that bonds pay, or from any increase in the bond’s price. Many people who invest in bonds because they want a steady stream of income are surprised to learn that bond prices can fluctuate, just as they do with any security traded in the secondary market. If you sell a bond before its maturity date, you may get more than its face value; you could also receive less if you must sell when bond prices are down. The closer the bond is to its maturity date, the closer to its face value the price is likely to be.

Though the ups and downs of the bond market are not 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 or through a mutual fund or exchange-traded fund, it’s important to understand how bonds behave and what can affect your investment in them.

The price-yield seesaw and interest rates

Just as a bond’s price can fluctuate, so can its yield—its overall percentage rate of return on your investment at any given time. A typical bond’s coupon rate–the annual interest rate it pays—is fixed. However, the yield isn’t, because the yield percentage depends not only on a bond’s coupon rate but also on changes in its price.

Both bond prices and yields go up and down, but there’s an important rule to remember about the relationship between the two: They move in opposite directions, much like a seesaw. When a bond’s price goes up, its yield goes down, even though the coupon rate hasn’t changed. The opposite is true as well: When a bond’s price drops, it’s yield goes up.

That’s true not only for individual bonds but also the bond market as a whole. When bond prices rise, yields in general fall, and vice versa.

What moves the seesaw?

In some cases, a bond’s price is affected by something that is unique to its issuer—for example, a change in the bond’s rating. However, other factors have an impact on all bonds. The twin factors that affect a bond’s price are inflation and changing interest rates. A rise 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.

The inflation/interest rate cycle at a glance:

    investment cycle

  • When prices rise, bondholders worry that the interest they’ve paid won’t buy as much.
  • To control inflation, the Fed may raise interest rates to get investors to purchase bonds.
  • When interest rates go up, borrowing costs rise. Economic growth and spending tend to slow.
  • With less demand for goods and services, inflation levels off or falls. Bond investors worry less about the buying power of future interest payments. 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 new inflation.

 

If inflation means higher prices, why do bond prices drop?

The answer has to do with the relative value of the interest that a specific bond pays. Rising prices over time reduce the purchasing power of each interest payment a bond makes. Let’s say a five-year bond pays $400 every six months. Inflation means that $400 will buy less five years from now. When investors worry that a bond’s yield won’t keep up with the rising costs of inflation, the price of the bond drops because there is less investor demand for it.

Why watch the Fed?

Inflation also affects interest rates. If you’ve heard a news commentator talk about the Federal Reserve Board raising or lowering interest rates, you may not have paid much attention unless you were about to buy a house or take out a loan. However, the Fed’rsquo;s decisions on interest rates can also have an impact on the market value of your bonds.

The Fed takes an active role in trying to prevent inflation from spiraling out of control. When the Fed gets concerned that the rate of inflation is rising, it may decide to raise interest rates. Why? To try to slow the economy by making it more expensive to borrow money. For example, when interest rates on mortgages go up, fewer people can afford to buy homes. That tends to dampen the housing market, which in turn can affect the economy.

When the Fed raises its target interest rate, other interest rates and bond yields typically rise as well. That’s because bond issuers must pay a competitive interest rate to get people to buy their bonds. New bonds paying higher interest rates mean existing bonds with lower rates are less valuable. Prices of existing bonds fall.

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

In addition to being affected by monetary policy and economic events, a bond is subject to the risk of potential default by the issuer.

 

Falling interest rates: good news, bad news

Just the opposite happens when interest rates are falling. When rates are dropping, bonds issued today will typically pay a lower interest rate than similar bonds issued when rates were higher. Those older bonds with higher yields become more valuable to investors, who are willing to pay a higher price to get that greater income stream. As a result, prices for existing bonds with higher interest rates tend to rise.

Example: Jane buys a newly issued 10-year corporate bond that has a 4% coupon rate–that is, 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 Jane as much for her bond, since they could buy a newer bond that would pay them more interest. If interest rates later begin to fall, the value of Jane’s bond would rise again–especially if interest rates fall below 4%.

When interest rates begin to drop, it’s often because the Fed believes the economy has begun to slow. That may or may not be good for bonds. The good news: Bond prices may go up. However, a slowing economy also increases the chance that some borrowers may default on their bonds. Also, when interest rates fall, some bond issuers may redeem existing debt and issue new bonds at a lower interest rate, just as you might refinance a mortgage. If you plan to reinvest any of your bond income, it may be a challenge to generate the same amount of 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 feel the effects of any Fed action almost immediately, but longer-term bonds likely will see the greatest price changes.

Also, a bond mutual fund may be affected somewhat differently than an individual bond. For example, a bond fund’s manager may be able to alter the fund’s holdings to try to minimize the impact of rate changes. Your financial professional may do something similar if you hold individual bonds. However, bond funds are subject to the same inflation, interest-rate, and credit risks as their underlying bonds, and if interest rates rise and bond prices fall, that can adversely affect a bond fund’s performance.

Focus on your goals, not on interest rates alone

Though it’s useful to understand generally how bond prices are influenced by interest rates and inflation, it probably doesn’t make sense to obsess over what the Fed’s next decision will be. Interest rate cycles tend to occur over months and even years. Also, the relationship between interest rates, inflation, and bond prices is complex, and can be affected by factors other than the ones outlined here. Remember, investments seeking to achieve higher yields also involve a higher degree of risk.

Your bond investments need to be tailored to your individual financial goals, and take into account your other investments. A financial professional may be able to help you design your portfolio to accommodate changing economic circumstances.

Contact our Peoples Investment Services, Inc. representative at 828-464-5620 or  www.raymondjames.com/PeoplesInvSvcs. 

This information, developed by an independent third party, has been obtained from sources considered to be reliable, but Raymond James Financial Services, Inc. does not guarantee that the foregoing material is accurate or complete. This information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. Investments mentioned may not be suitable for all investors. The material is general in nature. Past performance may not be indicative of future results. Raymond James Financial Services, Inc. does not provide advice on tax, legal or mortgage issues. These matters should be discussed with the appropriate professional.

Securities offered through Raymond James Financial Services, Inc., member FINRA/SIPC, an independent broker/dealer, and are not insured by FDIC, NCUA or any other government agency, are not deposits or obligations of the financial institution, are not guaranteed by the financial institution, and are subject to risks, including the possible loss of principal.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2014

Borrowing only works if you can afford it. Here’s how to borrow smart.

Borrowing only works if you can afford it. Borrowing money makes sense only when you can afford it. Getting a large sum of money is often necessary to purchase a car, fund a college education, purchase a home or expand a business. But your credit history, cash management skills and other factors are used to determine if you can afford to repay that loan. So be careful to build up a history of financial responsibility. Here are some tips to keep your credit history strong, and help prove that you can afford to borrow when the time comes:

  • Pay your bills on time
  • Inform yourself about credit (how it works, what it costs)
  • Pay attention to your credit activity (credit reports, etc.)

Inform yourself about borrowing. The importance cannot be over-stated. Peoples Bank has extensive information about credit available to help you with this learning process. So does the US government. Read the “Borrow” page on MyMoney.gov. The resources at the bottom of the page are particularly good.

10 Ways to Protect your Personal Information (and Your Money)

10 ways to protect your personal information and money‘tis the season to take special precautions.

The FDIC, the same people who insure all your deposits, have a vested interest in helping you avoid financial loss through scams. They work hard to do their part and so does Peoples Bank. Below are the highlights taken from the FDIC’s Consumer News web page titled “10 Ways to Protect Your Personal Information and Your Money”. We think the tips make good sense, especially this time of the year.

  1. Offers that seem too good to be true are probably a fraud.
  2. Someone you don’t know who sends you a check for more than you are due may be a fraudster.
  3. Be suspicious of unsolicited emails or text messages that ask you to click on a link. (The offer doesn’t have to be about money for your personal information to be the object.)
  4. Don’t give out personal information such as tax ID, driver’s license number and other key identification unless you initiated the conversation and are certain you are talking with a legitimate representative of a valid organization.
  5. Choose good passwords, and use different ones for each site. A password manager can help with this, so can your 10th grade English teacher who made you memorize Shakespeare.
  6. Be careful when using social networking sites. Remember, when the site and service are free – YOU are the target, YOU represent the access to money. (Check out tips on avoiding social media fraud)
  7. Check your bank transactions regularly. This will help you see anomalies quickly.
  8. Review your personal credit reports at least once a year. Often you can get a free report. See www.AnnualCreditReport.com for more information.
  9. Protect your personal financial documents. Leaving them laying around the house is not a good security procedure.
  10. Guard your mail. Your mailbox may contain bank statements or other documents containing sensitive information from time to time. Protect the access to that mail and don’t let it linger in unprotected areas.

The FDIC’s web page contains more details and links to resources that can help you. You can even listen to the full article if reading it is inconvenient. There is also a way to find back issues of the Consumer News tips and suggestions. This website is a great resource.

Top 10 Tips for Shopping Safely Online

holiday online shoppingDuring the surge of online shopping during the holidays, our Chief Technology Officer thought these reminders would be helpful. Here are 10 tips collected from security experts for shopping safely online:

  1. Make sure your computer and mobile device are fully up-to-date. Do you have the latest Windows or Mac patches installed? Is your tablet or phone running the most recent operating system update? Make sure they are!
  2. Are you free of malware? Designers of malicious software such as Trojans and key loggers grab your credit card information and site passwords, opening you up to fraudulent transactions. Run up-to-date antivirus software and configure it to fully scan your system from time to time (perhaps every day at 2 AM).
  3. Were you ever infected? If your machine ever did have nasty malware on it and was not completely wiped (or factory reset), think very hard before using it for any sensitive online activity. It’s virtually impossible to guarantee a once-compromised system is now safe.
  4. When it comes to shopping, go only to places you trust. If you are following links from fliers, marketing emails or websites, “hover” over the link to check the domain name before you click. If the last part of the domain name, (distinguished by punctuation and including the “dot com”) is not the same as what you know it to be, don’t go there!

    Examples:
    Good link (find the “dot com” and what precedes it): https://www.amazon.com/gp/product/8034-ui76?link=bold?cat=elec.

    Bad link: (see that there are 2 “dot coms”? The last one is where you will go when you click.) http://www.amazon.com.amazn.com/gp/product/8034-ui76?link=bold?cat=elec.

  5. Be particularly cautious of deals that are too good to be true. Online specials may be exciting, but the bad guys know what products get people clicking with wild abandon. Don’t follow retailers or marketing materials that you don’t recognize.
  6. Be particularly cautious of spam email through the holiday season. It always escalates in December, as does the successful fraud that drives it.
  7. If the website isn’t loading as “HTTPS”, close it down. Do not enter any information. The address should begin with https://.
  8. Offers requiring you to sign up or register may not be fraudulent, but be aware of precisely what information you are sharing and how the company will use your information. Malicious phishing emails are harder to spot if you also get a lot of legitimate marketing emails. Consider a throwaway email address for such offers; an email account you don’t use for online financial transactions.
  9. Never enter your bank card details into a pop-up window that appears before the payment stage. Never enter your PIN number anywhere online, period.
  10. Finally, be sure to keep receipts and some kind of record of the purchases you make online. Protect yourself in the event that you need to return something or dispute charges later.

We hope you have a fun, and safe holiday season. Our own experts are always ready to help you protect your financial assets. For more information, including a phone number if you need to talk to a live person are found on The Peoples Bank Online Security Tools resource page.