Interest rates, bond prices and inflation are related. Here’s how.
The Federal Reserve
“Part of the mission given to the Federal Reserve by Congress is to keep [consumer] prices stable–that is, to keep prices from rising or falling too quickly. The Federal Reserve sees a rate of inflation of 2 percent per year–as measured by a particular price index, called the price index for personal consumption expenditures–as the right amount of inflation.
“The Federal Reserve seeks to control inflation by influencing interest rates. When inflation is too high, the Federal Reserve typically raises interest rates to slow the economy and bring inflation down. When inflation is too low, the Federal Reserve typically lowers interest rates to stimulate the economy and move inflation higher.” ~The Federal Reserve of Cleveland
Interest Rate Risk
In general, low interest rates can be good for mortgage and other consumer loans because you will pay less to borrow money. However, low interest rates are not so good when you’re looking at the low interest credited on savings accounts and CDs.
But the main reason interest rate risk is considered a risk has to do with bond prices.
Bonds are basically fixed-rate loans with set maturity dates. Buying or selling them before maturity, when current interest rates might be higher or lower than the bond’s face value interest rate, is what affects their price.
In general, when interest rates go up, bond values go down. As bond prices increase, bond yields fall. Interest rate risk is common to all bonds, even U.S. Treasury bonds.
“The most important difference between the face value of a bond and its price is that the face value is fixed, while the price varies. The face value remains the same until the bond reaches maturity. On the other hand, bond prices can change dramatically.” ~Investopedia
Why You Should Care
Pre-retirees and retirees with money invested in the stock market often have the majority of their investments held in bonds after they reach age 50+ because in general, bonds are often considered “safer” than stocks.
A common principle used by some stockbrokers and bankers called “the Rule of 100” uses age to determine how much of their client portfolios are held in bonds versus stocks. The rule works like this: When you are 60, 60% of your portfolio will be in bonds versus 40% in stocks, when you’re 70, 70% will be in bonds versus 30% in stocks, etc. going up from there.
This shift to more bonds and less stocks as you get older happens automatically in many 401(k) “target date” funds as well.
Bonds Versus Bond Funds
Because the term “bonds” is often used interchangeably with “bond funds,” it’s important to know that some Wall Street experts consider bond funds to be correlated with stock market risk, and therefore not “safer.”
“A bond fund is simply a mutual fund that invests solely in bonds… An investor who invests in a bond fund is putting his money into a pool managed by a portfolio manager. Most bond funds are comprised of a certain type of bond, such as corporate or government bonds, and are further defined by time period to maturity, such as short-term, intermediate-term, and long-term. Some bond funds comprise of only one type…Still, other bond funds have a mix of the different types of bonds in order to create multi-asset class options.
“The types of bond funds available include: US government bond funds, municipal bond funds, corporate bond funds, mortgage-backed securities (MBS) funds, high-yield bond funds, emerging market bond funds, and global bond funds…Typically, a bond fund manager buys and sells according to market conditions and rarely holds bonds until maturity.
“In other words, bond funds are traded on the market, and the market prices on bonds change daily, just like any other publicly-traded security.” ~Investopedia
What’s Happening Now: The Headlines
- Inflation Fears
“Inflation is near a decade low and well below the 2% level the Federal Reserve targets as ideal. The usual conditions for rising inflation—tight job markets and public expectations of rising prices—are glaringly absent. Yet anxiety about inflation is at a fever pitch, among economists and in markets, where long-term interest rates have been grinding higher since President Biden unveiled plans for huge new fiscal stimulus.” ~Wall Street Journal
- Rock Bottom Interest Rates
“The Federal Reserve’s emergency rate cut back in March , which dropped the benchmark interest rate to zero, is likely here to stay…the Fed publicly stated that even if inflation starts to pick up again amid the economic recovery from the coronavirus pandemic, it doesn’t expect to raise interest rates any time soon as the labor market rebounds. Wall Street economists predict that these rock-bottom rates may be around for the next several years. In fact, after the 2008 Global Financial Crisis, the Fed kept benchmark rates low for seven years. While this means that borrowing becomes cheaper for those who can get approved for loans, it’s not such good news for savers.” ~CNBC
- Bond Yields Higher
“The 10-year U.S. Treasury yield climbed back above the 1.5% level on Thursday [3/4/21] after Fed Chair Jerome Powell said there was potential for a temporary jump in inflation and that he had noticed the recent rise in yields. The yield on the benchmark 10-year Treasury note rose to 1.541% shortly in afternoon trading. The yield on the 30-year Treasury bond pushed higher to 2.304%. Yields move inversely to prices.” ~CNBC
“If you hear that bond prices have dropped, then you know that there is not a lot of demand for the bonds. Yields must increase to compensate for lower demand.” ~The Balance
- Long-Term Bonds Face Nearly Zero Upside
“Buffett is bearish on bonds. Why does [Warren] Buffet think that “bonds are not the place to be these days”? Yields on Treasurys are near historical lows, and investors locking in these low returns by investing in long-term bonds face nearly zero upside with significant downside if rates rise.” ~Think Advisor
To Recap: Interest Rate Risk / Bond Risk / Inflation Risk
- Bond Risk: In general, when interest rates go up, bond values go down. Interest rate risk is common to all bonds, even U.S. Treasury bonds. A bond’s maturity and coupon rate generally affect how much its price will change as a result of changes in market interest rates.
- Inflation Risk: Inflation risk is the risk that rising costs will undermine purchasing power over time. The Fed will raise interest rates if inflation rises.
Inflation risk, bond risk, and interest rate risk can be managed through strategies like portfolio diversification, insured solutions that offer inflation adjustments, and by proper financial and retirement planning.
It’s more important than ever to make sure you are protected from multiple risks as you get closer to or are already in retirement. If you have any questions about your situation, please don’t hesitate to call us. Reach out to Element Wealth in Ridgeland, Mississippi here.