The role of bonds in different market environments
With investing, the one thing that’s certain, is that markets never stand still. So how do different market environments affect bonds?
Let’s begin by looking at interest rates.
Text on screen: Bonds and interest rates
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.
Why is this?
Well, let’s say you bought a bond yesterday for $100 that pays you an interest of 5 per cent.
And let’s then imagine that today, interest rates go up, such that the same bond is still being sold at $100, but with a higher interest payment, or yield of 6 per cent.
If you try to sell your bond today, no one would pay you $100 for it, because for the same price they could get the new bond with a higher yield. This means the bond you bought yesterday is now worth less than $100.
If you really want to sell your bond today, you’ll have to sell it at a discount. In other words, if interest rates go up, then a bond’s price generally falls.
But what if interest rates go down today, rather than up?
If that’s the case, then the bond you bought yesterday for $100 will be worth more, because a brand new bond at $100 today offers a lower yield. Your bond is more desirable.
If you want to sell your bond today, you could sell it at a premium. So you see, if interest rates go down, then a bond’s price generally rises.
Next, let’s look at what impact inflation has on bonds.
Text on screen: Bonds and inflation
The purchasing power of a bond’s fixed interest payments can decrease over time as inflation causes prices to rise. For example, if inflation is 2 per cent, it means the bond you bought for $100 with a nominal interest rate of 5 per cent will have a real interest rate of only 3 per cent.
That’s not the only impact of inflation on bonds. When inflation rises above a certain level, interest rates also tend to rise as central banks try to put pressure on consumers to reduce spending.
And you already know what happens when interest rates go up: that’s right – bond prices fall, which can reduce their total return.
But wait. There is a silver lining to rising rates, if you’re a long-term bond investor.
During periods of rising interest rates, not only are investors earning a higher forward yield, but regular coupon payments and maturities allow for reinvestment in new higher-yielding bonds that can also increase yield and boost total return over time.
Text on screen: Bonds during market downturns
In fact, one of the often forgotten benefits of bonds is their diversification benefits in a broader investment portfolio.
Historically, during a downturn when risk markets, like equities, sell off, bonds tend to perform well as they are seen as a safe haven by investors. Bonds may help dampen losses during these volatile times.
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