Bonds, interest rates, and inflation

Bonds, also known as fixed-income securities, play an important part in investment portfolios. They can help investors reduce risk, provide diversification, preserve your principal investment, and generate a periodic income stream.

While bonds have historically been less volatile than stocks over the long-term, they are not without risk. Bond prices can fluctuate, particularly during periods of rising or falling interest rates, and inflation can erode the purchasing power of their interest payments.

Let’s look at the nature of bonds, why interest rates and inflation can affect their value, and investing strategies that can help manage 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 greater 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.

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, decreasing demand for older bonds. Likewise, when rates decline, older bonds with their higher rates become more valuable.

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 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 is the rate at which the cost of goods and services increases in an economy over time. Several factors may lead to inflation, including higher production costs or greater demand for goods. The result is that higher inflation leads to a decline in the purchasing power of money.

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

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 Fed 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 running lower than its 2% goal.

One way to help manage risks associated with interest rate changes is to establish a bond ladder. With this strategy, you purchase bonds with different maturity dates to create a predictable 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 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 minimize 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.