Bonds, interest rates, and inflation

Insights from Morgan Stanley Wealth Management

07/01/21

Summary: Investors include bonds or fixed-income securities in their portfolio for any number of reasons—from their lower risk profile to their periodic interest payments, among other advantages. As with all investments, bonds also carry risks to be mindful of—including interest rate and inflation risk. Investors can use several strategies to help reduce the effect inflation and higher interest rates have on bonds to create an even lower risk income stream.

Amid ongoing inflation worries, tightening credit spreads, and a potential shift in the Federal Reserve’s pandemic-era stimulus program, fixed income investors have had a lot to digest recently. With many market watchers anticipating higher inflation and believing rising interest rates will define the next business cycle, it’s important to consider what these dynamics may mean for bonds. 

Bonds, also known as fixed-income securities, can produce several key benefits for investors. These products can help investors reduce risk, diversify their portfolio, preserve capital, and generate a periodic income stream. 

While bonds have historically been less volatile than stocks over the long-term, they are not without risk. Bonds can change in price, and inflation may affect their returns over the long-term, which can potentially cut into your gains.

Investors do have several strategies, like creating a bond ladder or using hedging techniques, that can reduce risks associated with bond investing.

Credit risk vs. interest rate risk

Bonds carry two main risks: credit risk and interest rate risk. Credit risk is the risk that the bond issuer will default on its debt, or not make its payments. When a company or government has a higher credit risk, they will likely have to pay higher interest rates to attract buyers.

Interest rate risk is the risk of the rise in interest rates, perhaps due to inflation, that can negatively affect bonds in several ways and ultimately reduce returns.

While many investors elect to hold their bonds until maturity, they can also be bought and sold on the secondary market. Interest rate risk is often of higher focus to investors seeking to liquidate a position prior to maturity—and potentially sell at a discount to their original purchase price—than those holding their bonds until their maturity date.

How interest rates affect bonds

Interest rates and bond prices move in opposite directions, like two sides of a seesaw. When interest rates rise, a bond’s face value declines because investors can find higher yields with newly issued bonds, so demand for older bonds decreases. Likewise, when rates decline, older bonds with their higher rates become more valuable.

Infographic - interest rates v bond prices seesaw

As the price of a bond changes, so does its investment return—commonly known as “yield.” While a bond's coupon is a fixed payment, its yield increases when the bond price decreases, and vice versa. So, changes in bond yields and bond prices also create a seesaw-like effect.

To gauge the interest rate risk of a particular bond, you should first understand its duration. A bond's duration is measured in years, but it is not the same as a bond's maturity date. A duration factors in both a maturity date and the bond's coupon. Bonds with longer durations are more sensitive to interest rate changes than bonds with shorter durations, so they carry more long-term interest rate risk.

Inflation and interest rates: the correlation

Inflation is the rate at which the cost of goods and services increases in an economy in a certain period of time. Several factors may lead to inflation, including higher production costs or higher demand for goods, perhaps driven by higher wages and people wanting to spend more. The result is that more inflation leads to a decline in the purchasing power of money.

In the US, the Federal Reserve can raise or lower its benchmark interest rate, called the federal funds rate, to try to either stimulate or slow inflation. The movement in federal funds rates also affects bond rates. The Fed aims for a 2% inflation rate as it sets it policies.

Inflation's effect on bonds

As inflation and interest rate trends are related, they are important to consider when investing in bonds.

Inflation can affect fixed-income investments more than other asset classes because, with higher prices for the consumer, fixed payments have less purchasing power. So, if a bond yields 2%, but inflation is 3%, the bond’s total return decreases.

If inflation starts rising faster-than-expected, the Federal Reserve could raise interest rates by a greater amount and at a quicker pace, which will cause the price of fixed-income investments, like bonds and brokered CDs, to decline. Similarly, the Fed may lower interest rates if inflation is lower than its 2% benchmark.

What to consider before you invest

As you invest in bonds, you may want to consider establishing a bond ladder to manage some risks associated with interest rate changes. With this strategy, you purchase bonds with different maturity dates to create an income stream that is prepared for rates to either rise or fall.

For example, you might purchase bonds with maturity date “rungs” of two years, four years, six years, and eight years. After two years, when your first bond matures, you can determine whether to purchase another eight-year bond to continue the ladder or reinvest those funds in another way. Bond ladders also reduce credit risk and increase liquidity.

You can also try to reduce interest rate risk by using Treasury Inflation-Protected Securities (TIPS), which are a type of Treasury security designed to keep pace with inflation. Some investors use floating-rate securities, which are tied to a benchmark index and regularly reset interest payments, to reduce interest rate risk – although they may have to assume more credit risk.

As with any investment decision, stay focused on your goals, time horizon, and risk tolerance when you invest in bonds.

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