To help tame inflation, the US Federal Reserve (Fed) raised its benchmark interest rate to its highest level in 15 years – now at the targeted range of 5.00%-5.25% after its May 2023 meeting. While the bulk of Fed rate hikes appear to be in the rearview mirror, the Fed is expected to boost the rate a little more in 2023. Whether a rising rate scenario qualifies as good or bad news, it may depend on your point of view – and time horizon.
When rates rise, bond prices fall, which can cause immediate pain to fixed income investors. However, rising rates are good for bond “income” or coupon returns. Rising rates mean more income, which compounds over time, enabling bond holders to reinvest coupons at higher rates (more on this “bond math” below). Overall, higher rates offer the potential for greater income and total return in the future. So, now that there is more income potential in the bond markets than there has been in many years, perhaps now is an opportune time to revisit some bond basics.
Bonds and interest rates
Bonds are debt securities issued by governments and corporations to fund their operations. Investors can purchase bonds from the issuer, who is then required to make interest payments on a regular schedule over a set number of years. (This is why bond investments are also known as fixed income.) The amount of interest paid reflects the prevailing interest rate environment at the time of issuance and is fixed over the life of the bond. This is where inflation concerns may enter the equation.
Bond prices, coupons, and yields
Regardless of whether a bond is issued by a government or a corporation, the mechanics of bond pricing are the same. Bonds are issued at a specific rate of interest that the issuer will pay to investors, known as the coupon. Once issued, the coupon never changes – but prevailing interest rates can. When that happens, an existing bond’s coupon rate may become more or less attractive by comparison, and that affects its price.
- When an existing bond has a higher coupon than a newly issued bond, it pays out more income. Investors may be willing to pay more to own it, driving its market price up.
- Conversely, when an existing bond has a lower coupon than current rates, investors may find it less appealing, and its market price may go down.
The relationship between a bond’s current price and its coupon is known as its yield, which is the amount of return an investor will realize on a bond, calculated by dividing its face value by its coupon. As market conditions affect a bond’s price, its yield will also change. For example: