Learn why interest rates and bond prices have an inverse relationship and why it matters for investors!
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If you’ve ever watched a playground seesaw in action, you probably know more about the relationship between interest rates and bonds than you think!
When one side goes up, the other goes down.
And in financial markets, interest rates and bond prices tend to do the same.
When interest rates rise, bond prices usually fall and vice versa. This is known as an inverse relationship.
But why does this happen?
Fixed income securities, like bonds, are essentially loans.
Governments or companies borrow money from investors and in return, promise to pay regular interest payments (known as coupons)... plus return the original investment when the bond matures.
For example, if you buy a bond paying 4% coupon rate, you’ll receive the 4% income each year until the bond reaches maturity.
This initial coupon rate is based on a few factors:
👉 Issuer’s credit quality – issuers with a higher risk of defaulting pay higher interest, whereas safer bonds offer lower rates
👉 Time to maturity – bonds with longer life span tend to pay a higher rate
👉 Interest rate – used as the market benchmark, bond issuers aim to be competitive amongst other investments
👉 Market demand – higher demand for a specific bond increases its price.
Let’s say you own a bond that pays a fixed 4% coupon rate.
Now imagine interest rates rise and new bonds start being issued paying 5%.
Suddenly, your 4% bond isn’t looking as attractive as before, because new investors can earn a higher return elsewhere.
If you wanted to sell your bond before maturity, you would likely need to sell it at a lower price to make it competitive. And that’s why bond prices tend to fall when interest rates rise.
Yup you guessed it - the opposite happens!
If new bonds are only offering 3% interest but you’re holding a bond paying 4%, that bond becomes appealing to other investors. As a result, they’re willing to pay more than its original price to lock in that higher income stream!
So no surprise, bond prices often rise when interest rates fall.
Interest rate decisions by central banks, like the Reserve Bank of Australia, can have a flow-on effect on bond markets.
When central banks bump up the cash rate to fight inflation, this can put short-term pressure on bond prices. That’s why, bonds can still experience price fluctuations despite being considered relatively stable investments.
Looking for a simple way to get exposure to bonds? Franklin Templeton offers a range of fixed income strategies that let you invest in a diversified basket of bonds, all in one tradable ETF.
So whether your goals are income, diversification or total returns, Franklin Templeton’s range of fixed income strategies can play a role as part of a diversified investment portfolio.
Find out more about Franklin Templeton’s fixed income capabilities
Interest rates will always move - it’s part of how economies function.
But understanding the relationship between rates and bonds can help investors keep things in perspective when markets shift.
Disclaimer:
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Flux does not operate under an Australian financial services licence and relies on the exemption available under section 911A(2)(eb) of the Corporations Act 2001 (Cth) and ASIC RG 36.66. Flux Technologies Pty Ltd provides general advice on credit products under our own Australian Credit Licence No. 530103. The product information presented does not constitute an offer and we are not recommending or suggesting any particular product.
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