How Do Interest Rates Affect Bonds?

After years of keeping rates at 0%, the Federal Reserve is talking about raising rates this year.  Because the economy remains extremely weak, mainly due to uncertainty in things like the effect of Obamacare on health insurance costs and employment rules, no quick change is expected.  Instead, predictions are that the Fed will raise rates by a couple of percentage points over the course of a couple of years.  They will also be looking for signs of weakness and take a pause or drop rates back down if needed.  Note that it is important that rates be raised because there is currently no flexibility to drop rates should the economy get worse since they are at zero (it’s not like banks can start charging you for leaving your money with them).  Plus, it’s really tough on retirees living on CD interest when rates are really low as they have been for many years now.

If you are an income investor, buying bonds and high yield stocks in an effort to generate an income from your investments, interest rate changes can have a big effect on your investments.  Hikes in interest rates tend to drive the prices of bonds and income producing stocks down.  If you’re a long-term investor, this may not really matter to you, but it is certainly unsettling to see your portfolio value drop, especially over a short period of time.  That’s why today I’ll be discussing the effect of interest rates on income investments.  In the next post I’ll discuss the best way to deal with changes ( and expected changes) in interest rates.

So why do changes in interest rates by the Federal Reserve have such an effect on the prices of bonds and income producing stocks?  The Federal Reserve has control of two key interest rates – the rate at which big banks charge each other for overnight loans and the rate they charge banks for loans at what they call the “Discount Window.”  They can also change the amount of cash reserves banks are required to hold in-house, reducing or increasing the amount of money they have available to loan out.  All of these factors have an effect on how easy it is to get a loan, which in turn affects the growth rate of the economy and inflation.
The control of those two interest rates allows the Federal Reserve to (very crudely) control other interest rates, such as savings account, CD, and money market rates.  If the Fed lowers their rates, banks lower the rates they offer to consumers since they can get money from the Fed or other banks without needing to deal with bank customers.  If the Fed raises rates, then banks will raise the amount they will pay in interest to consumers since they are now more eager to borrow from bank customers.
Now bonds and dividend paying stocks are also affected by these rates, although the effect is less direct than is seen with bank interest rates.  When people buy bonds and dividend paying stocks, they’re taking a risk that their money will not be returned (for example, if the company goes through tough financial times and can’t repay the bond or the stock price declines).  In exchange for this risk, investors require a higher rate of return from bonds and dividends than they can get from a bank CD.  If the rates on bank CDs increase, investors will sell bonds and dividend paying stocks and put their money in bank CDs.
New investors in bonds and stock will then offer a lower price for bonds and dividend stocks so that the interest rate that they receive is higher.  You see, a company issuing a bond will pay a fixed amount of money in interest each year through the life of the bond.  Likewise, companies tend to pay about the same amount out in dividends with perhaps small increases or decreases depending on how their business is doing.   Because the amount of money paid out is fixed, the effective percentage rate that a new investor gets depends on the amount he pays for the bond or the stock.  The more he pays, the less his interest rate.  The less he pays, the greater the rate.
The effect of an increase in bank interest rates is therefore to cause bond and income stock prices to decline.  Note that prices can also decline if there are fears that interest rates will rise far enough to cause the economy to slow, reducing future dividend payments and possibly causing some companies to fail and default on their bonds.  This will probably not happen with a small increase, but it certainly could if the Fed raises rates enough to shut-off the supply of money to companies that rely on borrowing to pay their bills.  Note also that if interest rates rise, the interest rates companies must pay on new bonds they issue also increases, so their borrowing costs increase and reduce the amount of money they have available to grow and expand their businesses.
In the next post, I’ll go into what income investors should do (or not do) in the face of a rate increase.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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