Understanding Interest Rates, Inflation, and Bonds (2024)

Owninga bond is essentiallylike possessinga stream of future cash payments. Those cash payments are usually made in the form of periodic interest paymentsand the return of principal when the bond matures.

In the absence of credit risk (the risk of default), the value of that stream of future cash payments is a function of your required return based on your inflation expectations. This article breaks down bond pricing, defines the term "bond yield," and demonstrates how inflation expectations and interest rates determine the value of a bond.

Key Takeaways

  • Bonds are subject to interest rate risk since rising rates will result in falling prices (and vice-versa).
  • Interest rates respond to inflation: when prices in an economy rise, the central bank typically raises its target rate to cool down an overheating economy.
  • Inflation also erodes the real value of a bond's face value, which is a particular concern for longer maturity debts.
  • Because of these linkages, bond prices are quite sensitive to changes in inflation and inflation forecasts.

Measures of Risk

There are two primary risks that must be assessed when investing in bonds: interest rate risk and credit risk. Though our focus is on how interest rates affect bond pricing (otherwise known as interest rate risk), a bond investor must also be aware of credit risk.

At the July 2023 FOMC meeting, the Fed announced it was raising the federal funds rate by 0.25%, moving its target range to 5.25%-5.50%. The Fed expects to continue raising rates in order to bring down inflation. As a result, the 10-year Treasury is hovering roughly around 4%.

Interest rate risk is the risk of changes in a bond's price due to changes in prevailing interest rates. Changes in short-term versus long-term interest rates can affect various bonds in different ways, which we'll discuss below. Credit risk, meanwhile, is the risk that the issuer of a bond will not make scheduled interest or principal payments. The probability of a negative credit event or default affects a bond's price –the higher the risk of a negative credit event occurring, the higher the interest rate investors will demand in exchange for assuming that risk.

Bonds issued by the U.S. Department of the Treasury to fund the operation of the U.S. government are known as U.S. Treasury bonds. Depending on the time until maturity, they are called bills, notes, or bonds.

Investors consider U.S. Treasury bonds to be free of default risk. In other words, investors believe that there is no chance that the U.S government will default on interest and principal payments on the bonds it issues. For the remainder of this article, we will use U.S. Treasury bonds in our examples, thereby eliminating credit risk from the discussion.

Calculatinga Bond's Yield and Price

To understand how interest rates affect a bond's price, you must understand the concept of yield. While there are several different types of yield calculations, for the purposes of this article, we will use the yield to maturity (YTM) calculation. A bond's YTM is simply the discount rate that can be used to make the present value of all of a bond's cash flows equal to its price.

In other words, a bond's price is the sum of the present value of each cash flow, wherein the present value of each cash flow is calculated using the same discount factor. This discount factor is the yield. When a bond's yield rises, by definition, its price falls, and when a bond's yield falls, by definition, its price increases.

A Bond's Relative Yield

The maturity or term of a bond largely affects its yield. To understand this statement, you must understand what is known as the yield curve. The yield curve represents the YTM of a class of bonds (in this case, U.S. Treasury bonds).

In most interest rate environments, the longer the term to maturity, the higher the yield will be. This makes intuitive sense because the longer the period of time before cash flow is received, the greater the chance is that the required discount rate (or yield) will move higher.

Inflation Expectations Determine the Investor'sYield Requirements

Inflation is a bond's worst enemy. Inflation erodes the purchasing power of a bond's future cash flows. Typically, bonds are fixed-rate investments. If inflation is increasing (or rising prices), the return on a bond is reduced in real terms, meaning adjusted for inflation. For example, if a bond pays a 4% yield and inflation is 3%, the bond's real rate of return is 1%.

In other words, the higher the current rate of inflation and the higher the (expected) future rates of inflation, the higher the yields will rise across the yield curve, as investors will demand a higher yield to compensate for inflation risk.

Note thatTreasury inflation-protected securities(TIPS) can be an effective way to offset inflation risk while providing areal rate of returnguaranteed by the U.S. government. As a result, TIPS can be used to help battle inflation within an investment portfolio.

Short-Term, Long-Term Interest Rates, and Inflation Expectations

Inflation and expectations of future inflation are a function of the dynamics between short-term and long-term interest rates. Worldwide, short-term interest rates are administered by nations' central banks. In the United States, the Federal Reserve's Federal Open Market Committee (FOMC) sets the federal funds rate. Historically, other dollar-denominated short-term interest rates, such as LIBOR or LIBID, have been highly correlated with the fed funds rate.

The FOMC administers the fed funds rate to fulfill its dual mandate of promoting economic growth while maintaining price stability. This is not an easy task for the FOMC; there is always debate about the appropriate fed funds level, and the market forms its own opinions on how well the FOMC is doing.

Central banks do not control long-term interest rates. Market forces (supply and demand) determine equilibrium pricing for long-term bonds, which set long-term interest rates. If the bond market believes that the FOMC has set the fed funds rate too low, expectations of future inflation increase, which means long-term interest rates increase relative to short-term interest rates –the yield curve steepens.

If the market believes that the FOMC has set the fed funds rate too high, the opposite happens, and long-term interest rates decrease relative to short-term interest rates –the yield curve flattens.

The Timing of a Bond's Cash Flows and Interest Rates

The timing of a bond's cash flows is important. This includes the bond's term to maturity. If market participants believe that there is higher inflation on the horizon, interest rates and bond yields will rise (and prices will decrease) to compensate for the loss of the purchasing power of future cash flows. Bonds with the longest cash flows will see their yields rise and prices fall the most.

This should be intuitive if you think about a present value calculation –when you change the discount rate used on a stream of future cash flows, the longer until cash flow is received, the more its present value is affected. The bond market has a measure of price change relative to interest rate changes; this important bond metric is known as duration.

What Is the Difference Between Nominal Rates and Real Rates?

Nominal interest rates are the stated rates, while real rates adjust for inflation. Real rates provide a more accurate picture of borrowing costs and investment returns by accounting for the erosion of purchasing power.

Why Do Bond Prices and Interest Rates Have an Inverse Relationship?

Bond prices and interest rates have an inverse relationship. When interest rates rise, newly issued bonds offer higher yields, making existing lower-yielding bonds less attractive, which decreases their prices.

Why Is the Yield Curve Important?

The yield curve illustrates the relationship between bond yields and their maturities. A normal curve slopes upward, indicating higher yields for longer maturities. Inverted or flat curves can signal economic uncertainty or impending recession. This curve helps shape communicate future expectations about global economies.

How Can Investors Safeguard Their Portfolios Against Interest Rate and Inflation Fluctuations?

Investors can diversify their portfolios to include assets like stocks, commodities, and inflation-protected securities to mitigate the impact of interest rate changes and inflation on their investments. If you're specifically interested in hedging your investment portfolio against high or increasing interest rates, consider discussing this investment decision with your financial advisor.

The Bottom Line

Interest rates, bond yields (prices), and inflation expectations correlatewith one another. Movements in short-term interest rates, as dictated by a nation's central bank, will affect different bonds with different terms to maturity differently, depending on the market's expectations of future levels of inflation.

The key to understanding how a change in interest rates will affect a certain bond's price and yield is to recognize where on the yield curve that bond lies (the short end or the long end) and to understand the dynamics between short- and long-term interest rates. With this knowledge, you can use different measures of duration and convexity to become a seasoned bond market investor.

Understanding Interest Rates, Inflation, and Bonds (2024)

FAQs

Understanding Interest Rates, Inflation, and Bonds? ›

The twin factors that mainly 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.

Should I buy bonds when interest rates are high? ›

Should I only buy bonds when interest rates are high? There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels.

Why do bonds go up when interest rates go down? ›

Most bonds pay a fixed interest rate that becomes more attractive if interest rates fall, driving up demand and the price of the bond. Conversely, if interest rates rise, investors will no longer prefer the lower fixed interest rate paid by a bond, resulting in a decline in its price.

Do I bond interest rates go up with inflation? ›

The interest rate on a Series I savings bond changes every 6 months, based on inflation. The rate can go up. The rate can go down. I bonds earn interest until the first of these events: You cash in the bond or the bond reaches 30 years old.

Why are bonds bad when inflation is high? ›

Inflation is a bond's worst enemy. Inflation erodes the purchasing power of a bond's future cash flows. Typically, bonds are fixed-rate investments. If inflation is increasing (or rising prices), the return on a bond is reduced in real terms, meaning adjusted for inflation.

How much is a $100 savings bond worth after 30 years? ›

How to get the most value from your savings bonds
Face ValuePurchase Amount30-Year Value (Purchased May 1990)
$50 Bond$100$207.36
$100 Bond$200$414.72
$500 Bond$400$1,036.80
$1,000 Bond$800$2,073.60

Should I invest in bonds now in 2024? ›

Positive Signals for Future Returns. At the beginning of 2024, bond yields, the rate of return they generate for investors, were near post-financial crisis highs1—and for fixed-income, yields have historically served as a good proxy for future returns.

Can you lose money on bonds if held to maturity? ›

After bonds are initially issued, their worth will fluctuate like a stock's would. If you're holding the bond to maturity, the fluctuations won't matter—your interest payments and face value won't change.

Is now a good time to buy bonds? ›

Bond yields have shot higher since March 2022, when the Federal Reserve began raising interest rates. The 10-year Treasury yield has soared to 4.67% Friday (April 26) from 1.72% Feb. 27, 2022. It even hit a 16-year high of 5% last October.

Why are bond funds losing money? ›

The share prices of exchange-traded funds (ETFs) that invest in bonds typically go lower when interest rates rise. When market interest rates rise, the fixed rate paid by existing bonds becomes less attractive, sinking these bonds' prices.

Do you pay taxes on I bonds? ›

How much tax do I owe on my I bonds? Interest on I bonds is exempt from state and local taxes but taxed at the federal level at ordinary income-tax rates.

What is a better investment than I bonds? ›

Bottom line. If inflation and investment safety are your chief concerns — TIPS and I-bonds deliver both. TIPS offer greater liquidity and the higher yearly limit allows you to stash far more cash in TIPS than I-bonds. If you're saving for education, I-bonds may be the way to go.

Is there a downside to I bond? ›

Variable interest rates are a risk you can't discount when you buy an I bond, and it's not like you can just sell the bond when the rate falls. You're locked in for the first year, unable to sell at all. Even after that, there's a penalty of three months' interest if you sell before five years.

Is it a good or bad time to buy bonds? ›

Short-term bond yields are high currently, but with the Federal Reserve poised to cut interest rates investors may want to consider longer-term bonds or bond funds. High-quality bond investments remain attractive.

Are I bonds a good investment right now? ›

I bonds issued from Nov. 1, 2023, to April 30, 2024, have a composite rate of 5.27%. That includes a 1.30% fixed rate and a 1.97% inflation rate. Because I bonds are fully backed by the U.S. government, they are considered a relatively safe investment.

Does buying bonds raise or lower interest rates? ›

When the Federal Reserve buys bonds, bond prices go up, which in turn reduces interest rates. Open market purchases increase the money supply, which makes money less valuable and reduces the interest rate in the money market. OMOs involve the purchase or sale of securities, typically government bonds.

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