The relationship between interest rates and bonds
The prices of bonds
and interest rates move in opposite directions. So if interest rates fall, bond prices rise. In other words, bonds have an inverse relationship with interest rates.
Much of what determines a bond’s price is based on market expectations. And how an economy is performing will determine what happens with interest rates.
If an economy is growing nicely, this means that employment is on the rise, wages are rising and the retail market is benefitting from the extra money in the economy.
This results in companies (who will issue bonds) demanding more cash as they want to take advantage of rising consumer demand.
Inflation (the cost of living) will also start to rise to reflect this demand. This usually results in a rise in interest rates. This is how the government controls inflation.
The bond market tends to anticipate this rise. On the other hand, if the economy is starting to show signs of pressure, this is when bonds tend to perform well.
The impact of inflation on bonds
A government uses interest rates to control inflation. And because of this, expectations of what’s going to happen with inflation tend to affect bond prices too.
When inflation is on the rise, it tends to decrease the price of bonds and increase their yield. In the bond market, this can lead to bondholders selling and taking their profits before the bond price falls.
When inflation is falling, as it is at the moment, this can attract buyers of bonds. They want to benefit from an improving bond price.
For example, yesterday’s data on consumer inflation
showed that it eased more than forecast. This led to an influx of bond buyers in the South African market
So there you have it. Why you should consider the impact of interest rates and inflation before you invest in bonds.
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