How Inflation Impacts Bonds and Interest Rates

How does inflation affect bonds? Are bonds good during inflation? What’s the relationship between bonds and interest rates? Here, your need-to-know guide to the ups and downs of the bond market.

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.

Owning bonds can contribute to your investment portfolio in two ways: the interest that bonds pay, or any increase in the bond's price. People tend to invest in bonds because they want a steady stream of income, and many are surprised to learn that bond prices can fluctuate, just as they do with any security traded in the secondary market. Bonds can be bought and sold before their maturity date; you may get more than face value, but could also receive less you sell when bond prices are down.

Though the movement of the bond market is not as dramatic as that of the stock market, it can still have a significant impact on your overall return.

The Seesaw Relationship Between Bond Prices and Yields

A bond’s coupon rate — the annual interest rate it pays — is typically fixed. However, its yield – the overall percentage rate of return on your investment at any given time – can fluctuate because the yield percentage is based on both the coupon rate and changes in its price.

Both bond prices and yields go up and down, but they move in opposite directions, like a seesaw. When a bond's price goes up, its yield goes down, even though the coupon rate doesn’t change. The opposite is true as well: When a bond's price drops, its yield goes up.

How Do Inflation and Interest Rates Affect Bond Prices?

Inflation and changing interest rates impact a bond’s price. A rise in either interest rates or the inflation rate usually make bond prices drop. Inflation and interest rates move in the opposite direction from bond prices.

If inflation means higher prices, why do bond prices drop? The answer is the relative value of the interest the bond pays. When prices go up, the purchasing power of the interest payments from a bond goes down. 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.

What Happens to Bonds When the Federal Reserve Board Raises Interest Rates?

You may not have paid attention to news about the Federal Reserve Board raising interest rates unless you were about to buy a house or take out a loan. However, the Fed's decisions on interest rates can also  impact the market value of 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, it may decide to raise interest rates to try to slow the economy by making it more expensive to borrow money. For example, when interest rates on mortgages go up, fewer people can afford to buy homes. That tends to dampen the housing market, 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.

Different Impacts on Different Bonds

Inflation and interest rate changes don't impact all bonds in the same way. Under normal conditions, short-term interest rates may feel the effects of any Fed action almost immediately, but longer-term bonds likely will see the greatest price changes. Also, a bond mutual fund may be affected somewhat differently than an individual bond. For example, a bond fund's manager may be able to alter the fund's holdings to try to minimize the impact of rate changes. Your financial professional may do something similar if you hold individual bonds.

Focus on Your Goals First

Though it's useful to understand how bond prices are influenced by interest rates and inflation, it doesn't make sense to obsess over what the Fed's next decision will be. Interest rate cycles occur over months and even years. Also, the relationship between interest rates, inflation and bond prices is complex, and can be affected by factors other than the ones outlined here.

Your bond investments need to be tailored to your individual financial goals and take into account your other investments. If you’re interested in discussing how bonds can fit into your portfolio, contact a Farm Bureau financial advisor.