As a bond investor, one must thoroughly understand interest rates, the most basic feature of bonds. The value of a bond investment is very much dependent on today's interest-rate environment and the potential future interest-rate moves.
Bonds as fixed income securities pay a set coupon rate, the rate used to calculate periodic interest payments on an issue. Two things affect the coupon rate: the issuer's credit quality and the issue's duration. In general, the better the credit quality and the shorter the duration, the lower the interest rate, and vice versa.
Unlike a coupon rate that stays constant, the actual yield(to maturity) on a bond fluctuates as the result of the changing supply and demand in the trading, any changes in current interest rates, as well as in the perception of future interest-rate moves. For an investor, the yield is the Aktuellezinsen coupon payments relative to the purchase price of the bond, which changes over time for the same above-mentioned reasons. And a bond yield moves in opposite direction to the price.
As interest rates have come down so much in the last couple of years, bond prices have risen accordingly and that has been good for investors. But the question now is that if interest rates can't drop much lower from today's historical low, what would that bode for investors, especially when inflation expectation starts setting in? One has to think about possible dropping in bond values down the road.
Interest Rate Sensitivity: Short Term vs. Long Term
Investors care a lot about how much their bond holdings are sensitive to any interest-rate change, because moves in interest rates will be reflected in the changing of the bond prices, thus the value of their holdings. In a rate-tightening environment or a would-be one, longer-term bonds are more sensitive to rate increases. This is because such a potential bond holder would be locked up for too long at a lower coupon rate.
Now the investor would be unable to earn any ongoing higher rates, and thus would demand a higher yield by paying less when purchasing the bond, effectively driving down longer-term bond prices. Should there be a future tightening and should the tightening become progressive as the current economic recovery continues moving forward, there could very well be losses of value on longer-term bonds.
On the other hand, shorter-term bonds would be less influenced by upward moves in rates in terms of investors demanding a higher yield and thus there wouldn't be much downward pressure on shorter-term bond prices. In fact, as investors contemplate whether interest rates will really go up, they would like to get into shorter-term bonds for the flexibility that shorter durations offer, potentially driving up shorter-term bond prices and delivering better returns for those shorter-term bond holders.
Should I Prepare For Higher Interest Rates?
How do I prepare for higher interest rates? And more importantly, do I need to prepare for higher rates? In general terms, it is very difficult to predict in what direction interest rates might go. That is because rates of interest are often predicated upon human behavior. However, currently interest rates are at historical lows. When an interest rate is at or near zero interest rate prediction becomes much easier. Interest rates are going to go up because that is the only direction they can move.
It is safe to say that interest rates are going to be moving higher over the balance of 2010. When they start to move and the magnitude of the move is harder to gauge. The central bank of Australia has already begun to inch rates higher. The Bank of Canada, which currently has prime set at .25%, anticipates not moving rates until the end of June 2010. It is thought that the American Fed might hold the line in raising rates until the 3rd or 4th quarter of 2010.
The direction in which the rates will move is dependent upon three separate but primary factors. Interest rates are affected by the supply and demand of available cash. They are also affected by the monetary policies adopted by the central banks of each country. Lastly, the rates of interest are affected by inflation rates. Interest rates tend to act in global synchronization, although the pace of moves and magnitude of moves can vary widely between countries.
The supply and demand of available money affects interest rates directly. The general rules of supply and demand apply in the financial industry just as they apply in every other industry. If the banking industry has access to a lot of money and the demand for this money (people who want mortgages or loans) is low then supply exceeds demand and interest rates stay lower. If the number of people seeking loans (demand) exceeds the amount of available cash (supply) you will begin to see rates raise. With the credit aktuelle zinsen crunch of the last 18 months supply has been limited but so has demand. Just remember when money is plentiful then money is cheap.