How Interest Rates Affect the Bond Market

The Federal Reserve, the central bank of the United States, plays a crucial role in shaping the nation’s economy. Its primary objective is to maintain economic stability by ensuring that the economy neither overheats nor falls into recession. One of the primary tools the Fed employs to achieve this is interest rate policy.

The Federal Reserve and Interest Rates

When the economy is experiencing robust growth, there’s a risk of inflation and asset bubbles forming. To counter these inflationary pressures, the Fed raises interest rates. Higher interest rates make borrowing more expensive, which can slow down economic activity and reduce inflationary pressures. Conversely, when the economy is sluggish, the Fed lowers interest rates 

The Federal Reserve’s primary tool for managing monetary policy is its ability to influence interest rates. When people talk about the Fed raising or lowering interest rates, they’re referring to the federal funds rate. This is the rate at which banks lend money to each other overnight. The central banks of other countries like India often follow the Fed while changing the interest rates.

The Federal Open Market Committee (FOMC) sets a target range for the federal funds rate. This target acts as a benchmark for other interest rates in the economy, such as the prime rate and the Secured Overnight Financing Rate (SOFR). By adjusting the federal funds rate, the Fed can indirectly influence the cost of borrowing for consumers and businesses.

Example:

• Scenario 1: Economic Boom: In 2021, the U.S. economy experienced a strong recovery from the COVID-19 pandemic. As the economy heated up, inflation began to rise, reaching a 40-year high in June 2022. To combat inflation, the Federal Reserve began raising interest rates in March 2022. By July 2024, the federal funds rate had increased by 5.25 percentage points from its near-zero level at the beginning of 2022.
• Scenario 2: Economic Recession: During the Great Recession of 2008-2009, the Federal Reserve aggressively lowered interest rates to stimulate economic activity. In December 2008, the federal funds rate was reduced to a range of 0-0.25%. This helped to prevent a deeper economic downturn and paved the way for a recovery.

The Bond Market and Interest Rates

The bond market, a vast global marketplace, is highly sensitive to interest rate changes. Bonds are essentially loans that investors make to governments or corporations. In exchange for lending their money, investors receive periodic interest payments and the principal back at maturity.

The relationship between bond prices and interest rates is inverse. When interest rates rise, the value of existing bonds typically falls. This is because new bonds issued at higher interest rates become more attractive to investors, making older bonds with lower interest rates less desirable. As a result, investors may be willing to pay less for older bonds, causing their prices to decline.

Conversely, when interest rates fall, the value of existing bonds typically rises. This is because new bonds issued at lower interest rates are less attractive to investors, making older bonds with higher interest rates more desirable. As a result, investors may be willing to pay more for older bonds, causing their prices to increase.

At first, the relationship between bond prices and interest rates can seem confusing, but understanding it is crucial to making informed investment decisions about bonds and other fixed-income products. If you plan to hold a bond to maturity, interest rate risk may not be as much of a concern for you. In that case, you’re primarily focused on receiving the bond’s face value, or par value, when it matures and earning the fixed interest payments over the life of the bond.

Most bonds are issued at or near par value, which is often Rs.1,00,000. When the bonds are first sold, the issuer collects this money from investors and promises to pay a fixed interest rate, known as the coupon rate, at regular intervals. Upon maturity, the bondholder receives their original investment—the par value—back.

However, once a bond is issued, it doesn’t just sit there until maturity. It can be traded in the secondary market, where its price may fluctuate based on supply and demand, changes in interest rates, and news about the financial health of the issuer. If interest rates rise, existing bonds with lower coupon rates become less attractive to investors, and their prices drop in the secondary market.

What happens to bond prices when interest rates rise

Let’s look at a simple example to illustrate this concept. Imagine you purchase a bond for Rs.1,00,000 with a 10-year maturity and a coupon rate of 6%. Each year, you’ll receive Rs.6000 in interest payments, and at the end of the 10-year period, you’ll get back your Rs.1,00,000 initial investment, assuming there’s no default.

Now, let’s say interest rates rise, and another investor buys a 10-year bond with the same Rs.1,00,000 par value, but this bond offers a coupon rate of 8%. The second investor will receive annual interest payments of Rs.8000 instead of Rs.6000. As a result, your bond with its lower interest rate becomes less attractive in comparison. 

If you wanted to sell your bond before the 10-year period is up, you’d likely have to sell it at a discount—below its par value—because it pays less income than newer bonds.

What happens to bond prices when interest rates fall

When interest rates fall, the opposite happens—bond prices generally rise. For example, if you had bought a bond with a 6% coupon rate and interest rates then drop to 4%, your bond would become more valuable. New bonds would only pay 4%, making your bond with a 6% coupon more attractive. In this case, investors might be willing to pay more than the bond’s par value, allowing you to potentially sell it for a profit.

However, if you decide to sell your bond after interest rates fall, you may face a new challenge. When you go to reinvest your proceeds, the current market rates are lower, meaning you’ll earn less interest on any new bond you purchase.

The role of inflation expectations in bond markets

Apart from interest rates, inflation expectations are another crucial factor that bond investors need to consider. Inflation, often regarded as the enemy of bond investors, erodes the purchasing power of a bond’s future interest payments. When inflation rises, the real value of the fixed coupon payments from bonds decreases unless interest rates rise to keep pace with inflation.

Inflation expectations are often measured by the difference in yield between inflation-linked bonds and nominal (or standard) bonds of the same maturity. This difference is known as the breakeven inflation rate and helps investors gauge the market’s expectations for future inflation. 

If investors expect higher inflation in the future, nominal bond yields may increase to compensate for the anticipated erosion of purchasing power, leading to lower bond prices.

Additional Factors Affecting Bond Prices

• Credit Risk: The perceived risk of the issuer defaulting on its debt can significantly impact bond prices. If an issuer’s creditworthiness deteriorates, its bonds may become less attractive, leading to lower prices.
• Economic Conditions: Economic factors such as inflation, GDP growth, and central bank policies can influence interest rates and, consequently, bond prices.
• Market Sentiment: Overall market sentiment and investor demand can also affect bond prices, especially in times of economic uncertainty or market volatility.

As an investor, it’s important to understand the relationship between bonds and interest rates. After all, the Indian Bond Market size is around $2.5 trillion.

You might not be focused on how interest rates can impact bond prices, but you should still understand the relationship between the two. Keep in mind, bonds can be an important component of a diversified portfolio. At Vested, we offer a range of INR bonds to meet your investment goals.

Conclusion

Understanding the relationship between bond prices and interest rates is crucial for investors. By carefully considering these factors, investors can make informed decisions about when to buy, sell, or hold bonds. It’s essential to remember that bond investing involves both income and potential capital gains or losses, and the optimal strategy will depend on individual financial goals and risk tolerance.