Bond Prices and Interest Rates have an Inverse Relationship
It is important to understand how a rising-rate environment impacts bond prices. A principle of finance is that when interest rates go up, bond prices go down, as shown in the table below.
Understanding Why Bonds Prices and Interest Rates Move Inversely
Here is an example of why and how this happens:
When a company issues a bond to raise money, the yield at which it is offered is dictated by both the risk-free rate and a credit risk premium. While the federal government has no credit risk, companies do. This is because companies do not have track records like that of the federal government, and do not have the same ability to generate revenue (e.g. hundreds of millions of people stop paying taxes versus some people stop buying a specific company’s products). This additional credit risk demands a higher yield from investors.
Now, let’s use the example of the risk-free rate being 2%, and a company’s bond yielding 5%. In this example, there is a credit risk premium on the company’s bond equal to 3%. What this means is that investors are satisfied with a 5% yield for the risk they are taking. Continuing with this example, if the risk-free rate was raised to 4%, what would happen to the price of the bond? Investors would demand the same credit risk premium of 3% which would mean that the bond would now need to yield 7% for investors to be satisfied with the higher risk being taken. This is done by reducing the price of the bond so the yield equals the demanded 7%.
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As part of our core value “Service Heart”, SFG enjoys giving back to the community. The winter months are a good opportunity for us to help out, so that’s exactly what we’re doing. As is tradition, we adopted a family through the Northern Nevada Children’s Cabinet.
The National Association of Personal Financial Advisors (NAPFA) hosts conferences bi-annually. In October, SFG’s Clarissa and Alyssa had the opportunity to attend the conference in Philadelphia, PA. They got to enjoy keynote speakers, networking opportunities, and a wide variety of educational programs. Some key themes and takeaways from the conference are outlined in this post.