Smart Bond Investing -- Yield and Return

Bonds and interest rates
Three cardinal rules:

  • When interest rates rise, bond prices generally fall.
  • When interest rates fall, bond prices generally rise.
  • Every bond carries interest rate risk.

Learn more about interest rate risk and other risks that come with investing in bonds and bond mutual funds.

Interest rate changes are among the most significant factors affecting bond return.

To find out why, we need to start with the bond's coupon. This is the interest the bond pays out. How does that original coupon rate get established? One of the key determinants is the federal funds rate, which is the prevailing interest rate that banks with excess reserves at a Federal Reserve district bank charge other banks that need overnight loans. The Federal Reserve (or "the Fed") sets a target for the federal funds rate and maintains that target interest rate by buying and selling U.S. Treasury securities.

When the Fed buys securities, bank reserves rise, and the federal funds rate tends to fall. When the Fed sells securities, bank reserves fall, and the federal funds rate tends to rise. While the Fed doesn't directly control this rate, it effectively controls it through the buying and selling of securities. The federal funds rate, in turn, influences interest rates throughout the country, including bond coupon rates.

Another rate that heavily influences a bond's coupon is the Federal Reserve Discount Rate, which is the rate at which member banks may borrow short-term funds from a Federal Reserve Bank. The Federal Reserve Board directly controls this rate. Say the Federal Reserve Board raises the discount rate by one-half of a percent. The next time the U.S. Treasury holds an auction for new Treasury bonds, it will quite likely price its securities to reflect the higher interest rate.

What happens to the Treasury bonds you bought a couple of months ago at the lower interest rate? They're not as attractive. If you want to sell them, you'll need to discount their price to a level that equals the coupon of all the new bonds just issued at the higher rate. In short, you'd have to sell your bonds at a discount.

It works the other way, too. Say you bought a $1,000 bond with a 6% coupon a few years ago and decided to sell it three years later to pay for a trip to visit your ailing grandfather, except now, interest rates are at 4%. This bond is now quite attractive compared to other bonds out there, and you would be able to sell it at a premium. 

Basis point basics
You often hear the term basis points -- bps for short -- in connection with bonds and interest rates. A basis point is one one-hundredth of a percentage point (.01). One percent = 100 basis points. One half of 1% = 50 basis points. Bond traders and brokers regularly use basis points to state concise differences in bond yields. The Federal Reserve Board likes to use bps when referring to changes in the federal funds rate.

Where to find economic indicators
Smart bond investors pay close attention to key or "leading" economic indicators, primarily watching for any potential impact they may have on inflation and, because there is a close correlation, interest rates. Various branches of the federal government keep tabs on many, but not all, of these leading indicators. Here are a few useful online resources:


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