By Alex Albert, CFP®
- A recap of the Federal Reserve’s approach during the pandemic
- How the latest course correction benefits investors
- Why rising rates make fixed income investments more attractive
Estimated read time: 3 mins
Interest rates represent the cost to borrow money whether as assessed on a credit card, a mortgage, or an auto loan. For investors, changes in interest rates directly impact the price of bonds and other fixed income investments. This past March, the Federal Reserve raised their benchmark rate for the first time since 2018 to a range between 0.25% and 0.50%, and most recently raised it an additional 0.50% to a range of 0.75% to 1.00%. Prior to this, interest rates had been at historic lows near 0% since the COVID-19 pandemic began in 2020. Who is the Fed, why are they raising rates, and is this a long-term positive for bond investors?
The Fed and Its Handling of the Pandemic
The Federal Reserve was created in 1913 when then President Woodrow Wilson signed the Federal Reserve Act into law. A primary Fed responsibility is to conduct monetary policy by influencing credit conditions in pursuit of stable prices and full employment. One way they influence monetary policy is by raising and lowering the benchmark “Fed funds” rate, which we recently wrote about in a separate commentary.
In 2020 when the COVID-19 pandemic hit, the Fed lowered the fed funds rate to a range of 0.0% to 0.25%, and then began buying trillions of bonds – a method known as Quantitative Easing – to support the economy and to spur growth. By pressuring interest rates lower, the cost to borrow money decreased, allowing companies and individuals to spend more on products and services. This monetary boost combined with increased government spending and other related factors have now raised inflation to the highest level since 1982 at 7.9% year-over-year.
How the Fed’s Course Correction Benefits Investors
While rising rates increase the cost of mortgages and other types of loans, they are to the benefit of savers and bond investors━even though the day-to-day pricing of existing bonds may decrease.
For example, let’s assume an investor owns a 10-year, $10,000 par bond that pays a 4% coupon (the bond price is 100% of its maturity value). If rates rise and the costs to borrow money increase, bond issuers such as corporations, municipalities, banks, and the U.S. Government increase the rate they pay to borrow money.
All things being equal, a new 10-year bond pays 5% from the same issuer. The bond the investor owns still pays 4%, and the investor will receive $10,000 par value at maturity, but the day-to-day price may drop close to $9,200. Did the holder of the 4% bond lose money? No, if the holder retains the bond to maturity, then the return will remain the same (4% per year) as when purchased.
The reason the market price drops is because the 4% coupon is less attractive than the current going rate of 5%. Market value is the price where willing parties will transact, and to compensate a buyer who can buy other bonds at a 5% return, a buyer would only be interested if the investor’s bond could be bought closer to $9,200, where they would earn a 5% return.
Rising Rates Make Fixed Income Investments More Attractive
In summary, although bond market values decline with rising rates, barring default by the issuer or selling of the bonds prior to maturity, investors lock in a positive rate of return and, importantly, cash flows from interest and maturities will be reinvested at higher interest rates. With a longer time frame, rising rates are a positive for investors looking for a safer alternative to stocks.
About the Author
Alex Albert is a Certified Financial Planner for Providence-based Lincoln Capital, a financial planning and wealth management firm. He is a graduate of the University of Rhode Island and earned CFP® certification from Bryant University.