Bond Interest RatesBonds
Interest Rates are the reward for lending and have two differing functions in debt obligations. Both divisions of interest reward you for being willing to lend money to financial firms and institutions. The first function compensates you for the inflationary loss you would suffer if you lent money to others. If you loan $600 now and receive $600 back in 10 years, your money would purchase more goods today than in the future. Interest payments mitigate pricing power loss.
The second function of interest is repayment for the money from the lender. If the money you loaned was given back to you after being adjusted only for inflation, there would be no compensation for lending in real terms. The dollars received would increase, but the amount of purchasable goods would remain the same. The second function of interest rates rewards you for lending money. This is your compensation beyond the inflation rate. When you add these two functions together, you have your nominal interest rate. All bonds have a nominal interest rate which attempts to counteract these functions. These are directly related to price.
Relative Interest Rates
The interest rates acquirable in the marketplace change the value of a bond. If below current interest rates, it will not be desired. The price people are willing to pay may fall below par value. Bonds selling below par are called “discount bonds”. If the bond is above current interest rates, investors will favor its returns. Its value will rise above par value, and these are called “premium bonds”. You should note that although bonds sell at premiums or discounts for a reason, it is not inherently better or worse to buy discount versus premium bonds. The actual benefit depends on the return versus the principal invested and how the bond fits into your overall strategy.
Interest Rates versus Bond Duration
The actual impact of interest rates on bonds depends on the Duration of the bond. Longer maturity bonds have longer durations, and they will suffer higher effects from interest rate changes. The reason is simple. Bondholders don’t want their money tied into long term bonds unless they’re guaranteed to pay higher interest rates than the market can provide. Purchasing long term commitments can result in earning lower market rates for a very long time. There’s also a possibility that bond issuers will default in the long term, since investors have no idea what can happen 5 to twenty years from now. These factors make long term bond prices highly volatile.
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