Understanding Interest Rates, Inflation, and the Bond Market

At Clayton Wealth Partners, we advocate an appropriate allocation of fixed-income investments via bonds or bond funds for all but the most aggressive investors. Bonds can provide a steady stream of income and, importantly, serve as a powerful diversifier that helps smooth the volatile returns of an equity allocation.

 

 

(For several reasons, we prefer bond funds over individual bonds, but since bond funds are simply a collection of individual bonds, we will refer to them interchangeably throughout this article.)

We think it’s important that all investors, regardless of their level of interest or expertise, become familiar with the basics of any investment to which they’ve allocated money. Here, we’ll discuss two important variables that can have a big impact on bond returns: changes in interest rates and inflation.

The Inverse Relationship Between Interest Rates and Bond Prices

Interest rates in the marketplace are constantly fluctuating for a whole list of reasons. And as rates move around, they can impact the market prices of bonds that have already been issued. Interest rates and bonds typically exhibit an inverse relationship, meaning that if interest rates increase, bond prices decrease, and vice versa. A simple example will help illustrate.

Let’s assume that Company ABC issues the following Bond A:

 

   Face value:                                        $1,000

   Coupon rate paid annually:          5%

   Annual interest payment:             $50

   Maturity:                                            10 years

   Redeemable at par (i.e., same as initial face value)

 

The 5% coupon was determined in part by what interest rates were at the time of issuance in general and characteristics specific to Company ABC, such as creditworthiness.

Now, in our very simplistic and highly unlikely scenario, let’s assume that interest rates drop 1% overnight, nothing has changed with Company ABC, and the very next day Company ABC takes advantage of the lower rates to issue Bond B:

 

   Face value:                                      $1,000

   Coupon rate paid annually:        4%

   Annual interest payment:           $40

   Maturity:                                          10 years

   Redeemable at par

 

The drop in interest rates provides an interesting situation for investors who wish to purchase Company ABC’s 10-year bonds. Investors must choose between two bonds with the same quality characteristics and the same length to maturity (for simplicity’s sake, we’re ignoring the insignificant one-day difference of issuance dates) but with meaningfully different coupon rates.

Bond A is now more valuable than before because its higher coupon rates are more attractive. Since financial markets are very quick to adapt to new conditions and information, rational investors will bid up the price of Bond A to a “premium.” The new price for Bond A set by the market will be that where its “current yield” syncs up to the prevailing market rates—in this case, 4%:

 

New current yield for Bond A = (Annual interest payment for Bond A) / (New price for Bond A)

4% = ($50) / (New price for Bond A), which rearranged is:

New price for Bond A = $50 / 4%

New price for Bond A = $1,250

 

At the new price of $1,250 for Bond A, annual coupon payments of $50 result in a current yield of 4%, the same as that of Bond B. Here, all else equal, rational investors would be indifferent between owning Bond A at the new price or Bond B because they both now offer the same 4% yield. So, when interest rates go down, bond prices go up.

Under the opposite scenario, where interest rates increase, the same outcome would be reached. Bond A’s lower coupon rates would be less attractive, so investors would bid down Bond A until its price reached a “discount” where its new current yield matched the higher prevailing rate. When interest rates go up, bond prices go down.

The Impact of Inflation on Bonds

You may have heard someone at some point mutter with despair, “A dollar just doesn’t go as far as it used to.” It might be easy to chalk it up to a grumpy person having a bad day at the cash register. But there’s truth to the quip because of inflation.

Inflation is simply the general increase in prices over time. Things generally cost more than they used to, and it’s very likely that they’ll cost more in the future than they do today. Inflation is an important element to consider when evaluating investment options, particularly bonds, because it directly impacts the investor’s “purchasing power,” or the ability to buy things.

The “nominal return” of an investment or portfolio is the stated return that generally shows up on a performance statement. While an investment’s nominal return is significant, greater emphasis should be put on its “real return,” which is the investment’s return adjusted for the impact of inflation.

Let’s assume that a bond pays a fixed income of 4% over time. During the same period, inflation averaged 2.5% a year. Here, the bond’s real rate of return is 1.5% a year.

What does this 1.5% real return indicate? In essence, the bondholder’s purchasing power has increased by 1.5% a year over time. If a real return is 0%, the investor’s return is just keeping up; he or she is neither getting ahead of nor falling behind price increases. In a worst-case scenario, an investor may achieve a negative real return—where annual inflation is destroying purchasing power.

Conclusion

Bonds are an important part of just about any well-diversified investment portfolio. When investing in fixed income, there are a lot of important considerations; we’ve highlighted just a couple.

If you’d like to learn more about fixed-income investments and the role they might play in your long-term portfolio, please reach out to us. At Clayton Wealth Partners, we serve as full-time fiduciary wealth advisors and are here to help with navigating the nuances of asset management, financial planning, and other important money matters. Our financial advice is focused solely on your best interests.

Contact us for a complimentary needs assessment phone call.

James Walden, CFA

As Partner and Chief Investment Officer, James Walden strives to maximize our clients’ long-term, risk-adjusted portfolio returns. This includes determining strategic and tactical asset allocations, as well as specific investment analysis and prudent rebalancing. Jim is also a partner and management team member. His expertise includes advanced investment research and valuation, and he is passionate about his role in helping clients reach and exceed their financial goals.