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.
This material is provided for general information purposes only. Investments and insurance products are not FDIC insured, not bank deposits, not obligations of, or guaranteed by Canandaigua National Bank & Trust or any of its affiliates. Investments are subject to investment risks, including possible loss of principal amount invested. Past performance is not indicative of future investment results. Before making any investment decision, please consult your legal, tax or financial advisor. Investments and services may be offered through affiliate companies.
FAQs
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.
Will bond funds recover in 2024? ›
As inflation finally seems to be coming under control, and growth is slowing as the global economy feels the full impact of higher interest rates, 2024 could be a compelling year for bonds.
What is the I bond rate for May 2024? ›
The May I Bond composite rate is 4.28% (US Treasury) which is 2.14% earned over 6 months. Breaking News: Official Treasury I Bond Rate announced! The May 2024 I Bond Fixed Rate is 1.30%.
What happens to I bonds when inflation goes up? ›
The interest rate on I Bonds can change every six months after your initial purchase of the bond, based on inflation. If inflation runs hotter, the rate can go up. If inflation cools off, the rate can go down. The fixed rate portion of an I Bond remains with the life of the bond.
Why do bonds go down when interest rates go up? ›
What causes bond prices to fall? Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value.
Should you buy bonds when interest rates are high? ›
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.
Is it a good time to buy bonds now? ›
Answer: Now may be the perfect time to invest in bonds. Yields are at levels you could only dream of 15 years ago, so you'd be locking in substantial, regular income. And, of course, bonds act as a diversifier to your stock portfolio.
Should I be investing in bonds right now? ›
What to consider now. We suggest investors consider high-quality, intermediate- or long-term bond investments rather than sitting in cash or other short-term bond investments. With the Fed likely to cut rates soon, we don't want investors caught off guard when the yields on short-term investments likely decline as well ...
Where are bonds headed in 2024? ›
Yields to Trend Lower
Key central bank rates and bond yields remain high globally and are likely to remain elevated well into 2024 before retreating. Further, the chance of higher policy rates from here is slim; the potential for rates to decline is much higher.
What is the downside of an I bond? ›
Key Points. Pros: I bonds come with a high interest rate during inflationary periods, they're low-risk, and they help protect against inflation. Cons: Rates are variable, there's a lockup period and early withdrawal penalty, and there's a limit to how much you can invest.
How to get the most value from your savings bonds
| Face Value | Purchase Amount | 20-Year Value (Purchased May 2000) |
|---|
| $50 Bond | $100 | $109.52 |
| $100 Bond | $200 | $219.04 |
| $500 Bond | $400 | $547.60 |
| $1,000 Bond | $800 | $1,095.20 |
You can cash in (redeem) your I bond after 12 months. However, if you cash in the bond in less than 5 years, you lose the last 3 months of interest. For example, if you cash in the bond after 18 months, you get the first 15 months of interest.
Is it better to buy bonds when inflation is high? ›
When you buy a bond, you are essentially lending the government or company money which they promise to repay after a set period of time, often with a set amount of interest or income. Inflation tends to be bad news for bonds because it eats into the future buying power of the fixed income they provide.
Is there anything better 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.
Should I buy bonds when inflation rises? ›
I bonds protect you from inflation because when inflation increases, the combined rate increases. Because inflation can go up or down, we can have deflation (the opposite of inflation). Deflation can bring the combined rate down below the fixed rate (as long as the fixed rate itself is not zero).
Is it better to buy bonds when interest rates are high or low? ›
Investing in bonds when interest rates have peaked can yield higher returns. However, rising interest rates reward bond investors who reinvest their principal over time. It's hard to time the bond market. If your goal for investing in bonds is to reduce portfolio risk and volatility, it's best not to wait.
Does inflation increase bond supply? ›
The expectation of higher inflation, other factors held constant, will cause borrowers to issue more bonds, driving the supply curve rightward, and bond prices down (and yields up). The Fisher Equation, i r = i – π e, explains this nicely.
Are stocks and bonds tied to the rate of inflation? ›
The shift in how bonds move with stocks is linked to the nature of inflation. The nominal interest rates that drive Treasury bond prices reflect both inflation expectations and real interest rates — when these are high, bond prices tend to be low.
Is now a good time to invest in bonds? ›
Answer: Now may be the perfect time to invest in bonds. Yields are at levels you could only dream of 15 years ago, so you'd be locking in substantial, regular income. And, of course, bonds act as a diversifier to your stock portfolio.
