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Education

Bonds 102: Understanding how Interest Rates Affect Bond Performance

Most people have experience with interest rates, thanks to a credit card, personal loan or mortgage. But when it comes to bonds, the role of interest rates is often less well understood.
What you will learn
  • How interest rates are determined
  • The difference between short-term and long-term rates
  • Why interest rates affect bonds
  • Why rising rates aren’t always bad for bonds

What determines interest rates?

Interest rates reflect the cost of borrowing money, and are a critical part of our economic system. At their most basic level, interest rates enable the lending and saving of money, which we need for our economy to function.

In many developed countries, there is a benchmark interest rate – sometimes called a base rate or policy rate – which is the rate at which the country’s central bank lends to other banks. The central bank raises and lowers this rate in response to economic conditions.

If the economy is growing quickly or inflation is too high, the central bank may increase interest rates. In turn, this often prompts retail banks to raise the rates at which they lend, pushing up the cost of borrowing. Banks may also raise their deposit rates, which makes savings more attractive.

On the other hand, if the economy is slowing, the central bank may reduce the base rate. In turn, retail banks may lower their rates, making it more attractive to borrow and spend money but less attractive to save it.

What’s the difference between short-term and long-term rates?

While central banks are responsible for setting a country’s short-term interest rates, they do not control long-term interest rates.

Instead, market forces of supply and demand determine long-term bond pricing, influencing the direction of long-term interest rates.

For example, if market participants believe a central bank has set interest rates too low, they may worry about a potential increase in inflation. To compensate for this risk, issuers of long-dated bonds will tend to offer higher interest rates. This may cause the yield curve, which reflects the relationship between long- and short-term bonds, to steepen.

Why do interest rates affect bonds?

Bond prices have an inverse relationship with interest rates. This means that when interest rates go up, bond prices go down and when interest rates go down, bond prices go up.

The reason: The price of a bond reflects the value of the income it delivers through its coupon (interest) payments. If prevailing interest rates (notably rates on government bonds) are falling, older bonds that offer higher interest rates become more valuable. The investor who holds these bonds can charge a premium to sell them in the secondary market.

Alternatively, if prevailing interest rates are increasing, older bonds become less valuable because their coupon payments are now lower than those of new bonds being offered in the market. The price of these older bonds drops and they are described as trading at a discount.

The risk posed by changing interest rates is called interest rate risk.

A figure shows a seesaw to show the inverse relationship of bond prices and interest rates. This case illustrates how when yields rise, prices fall. On the left-hand side of the scale, a circle is labeled “Yields Rise,” and is lifted higher relative to its counterpart on the right side of the scale, depicted with a circle labeled “Prices Fall.” That side of the scale is tipped lower.

Glossary of Key Investment Terms

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