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The Bond Series: Bonds and Interest Rates

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Bonds and Interest Rates

Welcome to the third part of The Bond Series where we will discuss the interest rates of bonds. If you missed it, the first part can be found here and the second part can found here.

In part one, we learned how and which entities issue bonds. In part two, we discussed the various types of bonds and we learned there are many! Now, let’s discuss interest rates and how they affect bond prices.

How Interest Rates affect Bonds

Interest rate changes are the most significant factors affecting bond returns. But, how? When you hear on the news that the Federal Reserve cut or increased interest rates, know that it impacts the return on bonds.

  1. When interest rates rise—bond prices generally fall.
  2. When interest rates fall—bond prices generally rise.
  3. Every bond carries interest rate risk.

To find out why, we need to start with the bond’s coupon. This is the interest the bond pays out as we found out in part one. One factor that drives the interest that the bond pays out is the federal funds rate. This is the prevailing interest rate that banks charge other banks that need overnight loans. That might sound shocking but banks do borrow from each other, and often. 

The Domino Effect

The federal funds rate is set by the Fed and maintained by buying and selling U.S. Treasury securities.

  1. When the Fed buys securities, bank reserves rise, and the federal funds rate tends to fall.
  2. When the Fed sells securities, bank reserves fall, and the federal funds rate tends to rise.

While the Fed doesn’t directly control this rate, it effectively controls it through the buying and selling of securities. This influences interest rates throughout the country, including bond coupon rates.

Federal Reserve Discount Rate

Another rate that heavily influences a bond’s coupon is the Fed’s Discount Rate. This is the rate at which member banks may borrow short-term funds from a Federal Reserve Bank. The rate is directly controlled by the Fed.

Why would banks need to borrow at the Fed’s discount window? Banks that lent out too much that day need to borrow funds overnight to meet the reserve requirement. Usually, they borrow from each other. The Fed provides the discount window as a back up in case they can’t get the funds elsewhere.  

Basis Point Basics

A basis point is one one-hundredth of a percentage point (.01). One percent = 100 basis points. One half of 1 percent = 50 basis points. Bond traders and brokers regularly use basis points to state concise differences in bond yields. The Fed likes to use basis points when referring to changes in the federal funds rate.

Where to Find Economic Indicators

Investors pay close attention to economic indicators, especially inflation because there is a close correlation to interest rates. Various branches of the federal government keep up-to-date on leading indicators. Here are a few online resources:

Conclusion

Now that you know how interest rates affect bond prices, you can use that to make an informed decision when investing in bonds. The important thing to remember is that change occurs in market interest rates almost daily. The movement of bond prices and bond yields is simply a reaction to that change. 

What’s next? The Bond Series: Bond Yield and Return (coming soon)

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