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. For investors who want to build a deeper understanding of the fixed income market, the relationship between bonds and rates is critical knowledge.

What determines interest rates?

Interest rates reflect the cost of borrowing money, and they are a critical part of our economic system. At their most basic level they 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.

Short-term versus long-term rates

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

Instead, it is the market forces of supply and demand that determine long-term bond pricing. In turn, this provides direction for 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.

For more information on the yield curve, refer to Series 2: Topic 3 – What is the yield curve and why is it important.

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Why 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.

For more information on bond pricing, refer to Series1: Topic 5 – What determines the price and performance of bonds.

Are rising rates always bad for bonds?

In the short run, rising interest rates may negatively affect the value of a bond portfolio.

However, over the long run, rising interest rates can actually increase a bond portfolio’s overall return. This is because money from maturing bonds can be reinvested into new bonds with higher yields.

For more information on rising rate environments, refer to Series 2: Topic 5 – What should investors do when rates rise?