Our discussions on bonds continue; after learning the bond basics, today we examine how bonds behave in an environment of high-interest rates, a relevant topic given the current interest rate environment. Before moving on to how bonds behave in a high-interest rate environment, we should first understand the reasons and conditions that generally create such an environment. Bond interest rates in a country are primarily influenced by the interest rates put forward by the government or monetary authorities like the Bank of Jamaica and the Federal Reserve in the USA. Each country wants to ensure healthy and sustainable economic growth.
Interest rates are one of the tools used by monetary authorities to balance the supply and demand of money in the economy and maintain stability. When the price of goods increases (inflation) out of control, the monetary authority steps in and increases policy interest rates. The higher rates encourage saving and investing and discourages spending which helps to bring down inflation.
Interest rates have an opposite relationship with bond prices. As the interest rate increases, the price of existing bonds fall. This is due to the simple fact that bond investors will earn more interest by purchasing new bonds that are being issued at higher rates than existing bonds. Let us understand this with the help of an example. Tom buys ABC bonds worth $1,000 with an interest yield of 5%. Suddenly, the market interest rates increase to 6%. As a result, no rational investor would be willing to purchase Tom’s old bonds at a yield of 5% as they can get a higher return of 6% on new bonds. The only way for Tom to sell his 5% bond to investors is to adjust the price. As a result, Tom’s ABC bonds will need to be sold at a price lower than the initial principal amount of $1,000 in order to remain attractive to investors.
There are many ways in which investors can protect and grow their money using bonds when interest rates are high. One of the most common ways is to reduce long-term bond exposure and invest in short- and medium-term bonds as they are less sensitive to interest rate changes. However, shorter-duration bonds often have the disadvantage of having a lower yield than longer term bonds.
Another strategy that is used by investment professionals is a bond ladder. Laddering is a strategy where an investor holds a series of bonds that mature at regular intervals. As the interest rates rise, investors have the opportunity to reinvest in the bonds at a higher interest rate.
Some other ways to strategize during rising interest rates are: creating a well-balanced portfolio, investing in a hard currency like the US Dollar, and investing in alternative debt assets such as private debt.
Once an investor understands how interest rates affect bond prices they can become more confident in investing in bonds. A qualified financial advisor should be able to explain the best strategy for your investment goal and of course, you should never be afraid to ask questions.
Anna-Joy Tibby is the AVP, Personal Financial Planning, at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual, and institutional investors. Visit our website at www.sterling.com.jm. Feedback: if you wish to have Sterling address your investment questions in upcoming articles, e-mail us at [email protected]