Bond Basics: How Interest Rates Affect Bond Yields

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 may boost the rate a little more in 2023. Whether a rising rate scenario qualifies as good or bad news 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 would 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:

Understanding bond math

Understanding the relationship between bond prices and yields helps explain why bond investors can lose money based on the current price of their bonds, even though the interest income may help offset some of the price decline. When interest rates rise, prices of existing bonds tend to fall, even though the coupon rates remain constant: Yields go up. Conversely, when interest rates fall, prices of existing bonds tend to rise, their coupon remains constant – and yields go down.

Quality matters

Not surprisingly, a bond’s quality also has direct bearing on its price and yield. Bonds are rated by independent agencies, with AAA/Aaa to BBB/Baa considered “investment grade.” These higher quality bonds generally have a lower yield than non-investment grade or non-rated securities because they are considered more likely to make all of their scheduled interest payments. Conversely, lower rated or “high yield” bonds pay higher coupon rates because there is a greater possibility that the issuer could default and fail to make payments.

Fixed income investment options

Investors consider fixed income for different reasons: a low-risk anchor for their portfolio, diversification from equities, inflation, or interest rate concerns, among others. Actively managed fixed income mutual funds can invest in bonds, notes and other securities issued by governments and corporations in the US and almost any country in the world. For example:

• US government bonds?are considered the highest quality and safest, as the US has never defaulted on its debt. Sovereign debt of other countries, such as emerging markets, may be riskier, depending upon the country’s economic or political stability.
• Corporate bonds,?ranging from investment grade to high yield, are typically seen as somewhat riskier than US government bonds, and may have higher interest rates to compensate for the additional risk.
• Bank loans?are debt issued to a company by a bank or similar financial institution and repackaged for sale to investors. As bank loans are typically secured by the issuer’s assets and rank senior to the company’s other debt, they are considered as less risky than other fixed income bonds. They sometimes offer a floating rate feature, where the adjusting rate can be helpful in a rising interest rate environment.
• Municipal bonds?are issued by a state, municipality, or county to finance its capital expenditures (construction of bridges, highways, schools). They are exempt from federal taxes and thus attractive for high income investors.
• TIPS (Treasury inflation-protected securities)?are bonds issued by the US government wherein the principal value increases in line with inflation changes. They aim to protect investors from a loss of purchasing power due to inflation.

Choosing the right bond fund

Specific bond funds may offer one of the fixed income instruments listed above, or some combination thereof. Multisector funds, for example, make tactical allocations to different sectors for added return potential, and may help to hedge against interest rate or volatility risk. Bond funds are offered across an array of risk/return objectives, credit quality (investment grade or high yield), and the desired duration of income needs, from short-term to long-term investments, perhaps for retirement. Funds may also satisfy investors’ desire to support sustainability by integrating ESG (environmental, social, governance) considerations into the investment manager’s research and decision making.

A fund’s specific investments can vary widely, based on the fund’s investment style, risk/return objectives, benchmark, and other factors. As a result, some fixed income funds may tend to be more stable, while others have greater potential for price fluctuations and growth.

With so many variables to consider, most financial advisors recommend actively managed fixed income mutual funds for their clients rather than individual bonds. Active bond funds offer experienced professional managers, a specified investment objective, diversification, and daily liquidity. For investors seeking exposure to certain fixed income indices, sectors, duration ranges, etc., the flexibility of actively managed ETFs may be a consideration.

I would be happy to discuss the right mix of fixed income investments for your needs. Depending on your age, risk tolerance, and overall income needs, I can help you maintain an appropriate level of income diversification in your portfolio.