Utilizing Economic Data to Improve Bonds Investment Performance
It is a basic economic fact that whenever the Federal Reserve Board raises or lowers interest rates to guard against inflation or to stimulate the economy, the stock and bond markets fall or rise accordingly. Bond prices are driven by inflation (or recession) and rising or falling interest rates. If you are planning to invest in bonds, or even stocks for that matter, you need to understand why this happens.
Inflation means that something costs more today than yesterday, and will cost even more tomorrow. Inflation eats away at the value of your money over time. Inflation is caused mainly by rising wages without a corresponding rise in worker productivity. When available labor is in short supply, companies compete to attract workers bid offering higher wages and salaries. A secondary cause of rising inflation occurs when the resulting increase in spending of those higher wages boost demand for products faster than they can be supplied to the market. When demand exceeds supply companies often raise their prices. So inflation is often a by-product of strong economic growth.
Interest rates are the price of borrowing money. When prices in general rise, so does the cost of borrowing money. When inflation starts becoming a concern, the Fed steps in and raises interest rates in an effort to curb borrowing which has the effect of curbing spending. Anxious lenders often start charging more for loans even before the Fed takes any action.
Now, if you are a bond investor that is essentially lending money to a company or the government, and you aren't going to be repaid for a long period of time, you are going to start demanding more interest to protect yourself. You start looking for a yield that is high enough to offset inflation plus a profit. This results in bond prices falling for those bonds that do not pay the best interest rates.
Many investors do not realize just how higher interest rates start to put a runaway economy back on track. The fact is that higher interest rates result in higher home mortgage costs. This results in a decrease in new home building. Nothing affects the economy more than home building. When construction activity increases, the economy grows faster, and when it slows, so does the economy. Now, rising interest rates also make it more difficult for companies to borrow money to finance growth and business expansion cools down. As the economy begins to slow there is less demand for labor and raw materials. When supply starts to exceed demand, wages and prices fall and inflation is defeated.
This is the important part for bond investors: The Bond Market does poorly when interest rates rise. While it is true that bond interest payments go up, the prices of lower-paying bonds that have already been issued decline to a point where they can cancel out any profits that interest rates may have provided. This is why rising interest rates spell bad news for bond holders.
If you are planning to invest in bonds, particularly ones with long maturity dates, you'd be wise to keep an eye on the economy. Don't let inflation catch you unprepared!