Bonds are a popular investment option among investors because they offer consistent income, reduced risk, and diversification. Like any other investment instrument, there are several factors that affect bond yields. One key factor is the interest rate, which influences a bond’s yield to maturity.
The value of existing bonds increases as interest rates decline and vice versa. In this blog, we explore the impact of interest rates on bonds, yields, and the market itself.
How do Rising and Falling Interest Rates Affect Bonds?
Bonds have long been considered a safer investment option for investors. Historically, they have helped keep portfolios afloat during stock market downturns. The Bloomberg US Aggregate Bond Index, however, experienced its worst performance in decades, plunging 13%. This was due to the US Federal Reserve increasing interest rates in 2022 to combat inflation.
This is a prime example of how, when interest rates increase, bond prices decrease. This happens because older bonds with lower fixed interest payments (also called coupons) are less attractive than newer ones with higher yields. To compensate for this lower yield, the price of older bonds in the market decreased.
Example:
Suppose you have a bond that pays 2% per year. When other bonds in the market begin to pay 3%, your 2% bond becomes less attractive and valuable, since nobody would want a lower rate when they can get a better one with equal risk.
When the central banks lower interest rates, your bonds with a higher coupon value become more valuable than before. This drives their market prices upwards.
What is the Impact of Interest Rates on Bond Yields?
Yield is the actual return you receive on a bond. When interest rates go up, bond prices go down, and the bond yields go up (as you’re paying less for the bond but still receiving the same fixed coupon rate). This inverse relationship between price and yield is the primary mechanism for understanding movement in the bond market.
For every year of duration, the price of a bond will fluctuate in the opposite direction by around 1% for every 1% change in interest rates. For instance, if the interest rate decreases by a percentage point (100 basis points), the price of a 7-year bond would increase by around 7% (= 1% × 7). Likewise, if interest rates increase by that amount, the price will decrease by approximately 7%.
How to Navigate Bonds During an Interest Rate Hike?
Rising interest rates do not mean you should avoid bonds entirely. Instead, you should consider adjusting your investment strategy.
1. Shorter Duration Bonds Are Safer
“Duration” refers to a bond’s sensitivity to changes in interest rates. Long-duration bonds fall more in value when interest rates increase. You can manage this risk by investing in short-duration bond funds or unit trusts, which have lower interest rate sensitivity and tend to perform better during the rate hike cycle.
2. Invest in Floating Rate Instruments
Unlike fixed-rate bonds, floating-rate bonds cause coupon payments that adjust based on interest rates changes. As rates rise, so do your returns. Consider investing in unit trust that contains floating-rate securities or funds that adapt to higher-yielding environments.
3. Ladder Your Investments
Bond laddering involves spreading your investment across multiple bonds with staggered maturities, such as 1, 3, 5, 7, and 10 years. When a bond matures, you reinvest the proceeds into a new long-term bond with a higher interest rate.
4. Reinvest at Higher Yields
New bonds offer higher yields when interest rates rise. Take advantage of this by reinvesting matured capital into new bonds with higher returns, particularly if you hold short-duration bonds, a bond ladder, or unit trusts.
How to Understand Central Bank Signals
In Singapore, the Monetary Authority of Singapore (MAS) does not use interest rates as an explicit policy tool like the US Federal Reserve. Instead, MAS focuses primarily on exchange rate policy. However, when global interest rates change, domestic bond markets are also affected.
For instance, if the Fed increases rates multiple times, US Treasury yields will increase. As a result, Singapore dollar-denominated bonds may need to offer higher yields to remain competitive. This causes domestic bond prices to adjust accordingly.
Conclusion
Interest rate changes and bond prices are inversely related: when interest rates rise after a bond is issued, bond prices fall, and vice versa.
The investments made by the fund can vary significantly depending on its investing strategy, benchmark, risk/return objectives, and other variables. As a result, some fixed-income funds may offer greater stability, while others may be more vulnerable to price fluctuations.
