Bonds can yield profits in two ways

Neil Brown

There are two fundamental ways consumers can profit from owning bonds: the interest that bonds pay or an increase in the bond’s price. Many people who invest in bonds because they want a steady stream of income are surprised to learn that bond prices can fluctuate. If you sell a bond before its maturity date, you may get more or less than its maturity value. The closer the bond is to its maturity date, the closer it will be to its surrender value.

Though the ups and downs of the bond market are not usually as dramatic as the movements of the stock market, they can still have a significant impact on your overall return. If you’re considering investing in bonds, it’s important to understand how bonds behave and what can affect your investment in them.

Bond prices go up and down, but there’s an important rule to remember about the relationship between bond prices and interest rates: they move in opposite directions, much like a seesaw.

When interest rates go down, a bond’s price goes up, and when interest rates go up, bond prices go down. While this impacts the yield of the bond, it does not affect the bond owner’s interest income.

In some cases, a bond’s price is affected by something that is unique to its issuer – for example, a change in the bond’s rating. However, the twin factors that affect a bond’s price are inflation and changing interest rates. A rise in either will tend to cause bond prices to drop.

If you’ve heard a news commentator talk about the Federal Reserve Board raising rates, you may not have paid much attention unless you were about to buy a house or take out a loan. However, the Fed’s decisions on interest rates can also have an impact on the market value of your bonds, as rising rates lead to falling bond prices. Though it’s useful to understand generally how bond prices are influenced by interest rates and inflation, it probably doesn’t make sense to obsess over what the Fed’s next decision will be. Interest rate cycles tend to 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.

A distant concern related to the Fed is when will they raise the target interest rate? When this happens, other interest rates and bond yields will rise, as well, which leads to a loss in your existing bond’s value. Inflation and interest rate changes don’t affect all bonds equally. 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. You can position your bond portfolio to better weather this price volatility by holding shorter-term bonds. For example, a 1 percent rise in interest rates would lead to an approximate 8 percent drop in a 10-year bond but only a 1 percent to 2 percent drop in a three-year bond price.

While we do not know the exact date rising rates will start, we are certain that rates are set for a steady and long-term rise for the first time in decades. As such, your bond investments need to be tailored to your individual financial goals, and take into account your other investments. A financial professional can help you design your portfolio to accommodate changing economic circumstances.

Life is a journey; plan for it.