Laurie Haelen, AIF®
Senior Vice President - Manager of Investment and Financial Planning Solutions
[email protected]941.366.7222 x41970
2022 has certainly been an interesting and somewhat stressful
year for investors, with high inflation and market volatility
dominating the financial news daily. During all of this, even
bonds—historically less risky than stocks—have decreased
in value year to date. To understand why, you must first
understand the nature of bonds and why interest rates and
inflation can impact the prices.
There are two fundamental ways that you can profit from
owning bonds: from the interest that bonds pay, and 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.
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, its yield goes up. That's true not
only for individual bonds but also for the bond market as a
whole. When bond prices rise, yields in general fall, and vice
versa.
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 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.
The reason 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.
Inflation also affects interest rates. This year has certainly been
one where there is a lot of talk about the Federal Reserve Board
trying to tame inflation by raising interest rates. However, the
Fed'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, like
this year, it may decide to raise interest rates 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, as we have seen this year, and investors
begin 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 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.
Bonds are an important asset class to have in an investor’s
portfolio. 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.
Your bond investments need to be tailored to your individual
financial goals and integrate with your other investments. Our
team may be able to help you design your financial plan to
accommodate changing economic circumstances.
©2022 Broadridge Investor Communication Solutions, Inc. All rights reserved. This material provided by Laurie Haelen.
This material is provided for general information purposes only. Past performance is not indicative of future investment results. Any investment involves potential risk, including potential loss of capital. Before making any investment decision, please consult your legal, tax and financial advisors. Non-deposit investment products are not bank deposits and are not insured or guaranteed by Canandaigua National Bank & Trust or its affiliates, or any federal or state government or agency and are subject to investment risks, including possible loss of principal amount invested.