To fully understand how your financial portfolio and financial goals are tied to a successful economy, it’s important to understand how interest rates work. Today’s post looks at how interest rates operate and how specifically those interest rates affect the investment in bonds.
Understanding Interest Rates
Let’s start at the beginning: what is an interest rate and how is it determined? An interest rate is the amount of return generated from a loan. Because there is always a chance a loan may not be repaid, the interest rate is the reward for accepting this risk. In the United States interest rates are set by the Federal Reserve committee. This committee, formed in 1913 to regulate monetary policy and stabilize the U.S. economy, is comprised of a Board of Governors made up of seven presidential appointees and confirmed by the U.S. Senate. Each board member serves 14 year terms. Dr. Janet Yellen currently serves as the chair of the board. Often, this federal agency is referred to as “the Fed”. The committee meets eight times a year to, among other responsibilities, review and adjust interest rates to stir the U.S. economy to positive growth. These interest rates determine the rate at which banks can borrow money and thus the rate offered to consumers.
How Interest Rates Affect Inflation and Recession
Many things factor into the health of the economy. The economy can generally be in three states; healthy, recessive, or inflated; though, in reality, it shifts through various degrees of these states. When the economy is in a recession, the Fed responds by lowering interest rates to spur economic activity. Lowered interest rates encourage banks to increase lending and encourage consumers to spend more. At lower interest rates, ‘big purchases’ like homes, cars, and higher education are more affordable. The spur in spending often leads to increased revenues for businesses and thus increased needs for workers, decreasing unemployment.
On the other hand, when the economy is moving to inflated rates, meaning the value of money is decreasing, the Fed will typically increase interest rates. Increasing interest rates slows economic growth; it means consumers have less discretionary spending power and businesses may see revenues flat line or even decrease, and therefore businesses will also slow spending and hiring. This will also cause inflated prices to decline, therefore returning the value of money to the ideal market prices.
How Bonds React
A bond is a form of a loan to a business or to the government. Purchasing shareholders are able to “loan” a set amount of money with determined interest rates (coupon rates) and a repayment date (maturity date). The interest rates for bonds are set at the current Federal interest rate. Once purchased, interest rates on bonds are locked in for the maturity of the bond. Therefore, the value of bonds are conversely linked to interest rates. When interest rates increase, the value of existing bonds decreases. When interest rates decrease, the value of existing bonds increases.
To understand this concept fully, let’s look at an example: imagine you purchase a bond for $2,000 with a maturity date of 5 years at today’s current interest rates of 0.5%. You will receive annual interest payments of $10 ($2000 multiplied by 0.5%) for 5 years, plus the return of principal at maturity. Now consider what happens when interest rates increase during this time period. Let’s say interest rates rise to 1%, this means your bond (with a .5% interest rate) effectively becomes less valuable. New bonds are trading at 1% rate of return but you’re locked into a bond with a now lower interest rate. Investors can now buy into a bond using the same $2000 investment and get a return of 1%, or $20 annually, double the amount of return of your bond rate. Therefore as interest rates increase, the value of bonds decreases. Alternately, when interest rates decrease, the value of bonds increases.