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FAQ: How do interest rates affect the bond market?

by Rachel MillsMarch 22, 2023
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The bond market, typically considered a safe, stable place to park your cash has been destabilized by higher interest rates.

Bonds are essentially loans that investors make to issuers (such as governments or corporations) in exchange for regular interest payments and the eventual return of their principal investment. When interest rates rise, bond prices tend to fall, and vice versa. Here’s why:

When interest rates go up, newly issued bonds offer higher yields than existing bonds. This makes the existing bonds less attractive to investors, as they can get a better return by investing in the new bonds. As a result, the demand for existing bonds decreases, and their prices fall. Conversely, when interest rates fall, newly issued bonds offer lower yields than existing bonds, making the existing bonds more attractive to investors. This increases demand for existing bonds, which drives up their prices.

In addition to affecting bond prices, changes in interest rates can also impact the overall bond market in a few other ways:

  1. Duration Risk: The longer the term of a bond, the more sensitive its price will be to changes in interest rates. This is known as duration risk. As a result, long-term bonds are more vulnerable to interest rate changes than short-term bonds.
  2. Inflation Risk: Inflation can erode the purchasing power of the interest and principal payments that bond investors receive. When inflation expectations rise, interest rates tend to rise as well, to compensate investors for the increased inflation risk.
  3. Credit Risk: Changes in interest rates can also impact the credit risk of bonds. If interest rates rise, it can become more difficult for issuers to pay their interest and principal payments, which can increase the likelihood of default.

A key sign to look for is the inversion of the yield curve.

The yield curve is a graph that shows the yields (interest rates) of bonds with different maturities, typically U.S. Treasury bonds. The yield curve can be upward-sloping (also known as normal), flat, or inverted, depending on the difference in yields between short-term and long-term bonds.

When the yield curve inverts, it means that the yields on short-term bonds are higher than the yields on long-term bonds. This is an unusual occurrence because normally investors require higher yields for lending their money over a longer period, and therefore, the yield curve is upward-sloping, with longer-term yields higher than short-term yields.

An inverted yield curve is significant because it is often seen as a warning sign of an impending recession. This is because an inverted yield curve implies that investors are willing to accept lower yields for long-term bonds because they are pessimistic about the future economic outlook. In other words, investors are more concerned about preserving their capital than earning higher returns, indicating a lack of confidence in the economy.

Historically, an inverted yield curve has preceded every U.S. recession since 1950. However, an inverted yield curve does not necessarily mean that a recession is imminent. Other factors, such as geopolitical risks, trade tensions, and global economic conditions, can also impact the economy and financial markets.

In summary, an inverted yield curve is a warning sign that the economy may be heading towards a recession, and investors should pay close attention to economic indicators and market conditions.

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