With steep tariff announcements causing economic uncertainty, along with stubborn inflation, the US Federal Reserve (Fed) decided at its May meeting to hold its benchmark interest rate steady at 4.25% to 4.50%. However, the Fed is still expected to cut rates a few times in 2025 into 2026. The Fed can lower or raise its short-term rate when needed to promote maximum employment and price stability, aiming to keep inflation at a healthy level in the 2% range.
Whether today’s higher-for-longer interest rate environment qualifies as good or bad news may depend on your point of view – and time horizon. Higher rates offer the potential for greater income and total return in the future. But when interest rates are cut, bond prices generally rise, as new bonds issued at lower interest rates become more attractive to investors. This makes existing bonds with higher interest rates less desirable, which decreases their price. So, now that there is attractive income potential in the bond markets, perhaps it 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: