The Two Components To Bond Returns
Bonds generate returns for you in two ways: interest and appreciation.
You will make money every quarter or every year through interest payments made by the borrower. You will also make or lose money when you sell your bond or hold it until maturity and are repaid the agreed upon loan amount. This is the appreciation component.
Bonds have historically seen the majority of their returns come from interest rather than appreciation. In this they are the opposite of stocks, which see the majority of their returns come from appreciation and only a fraction from dividends each year.
Why The Interest Rate Increases
The Fed is the biggest driver of changes in the interest rate. With various monetary policy tools, they are able to flood the market with extra dollars and buy up bonds or go out and become a borrower themselves. In this way they can control both supply and demand such that the interest rate moves towards their target. The Fed traditionally moves the interest rate in the best interest of the economy.
When the economy is extremely hot and inflation is climbing fast, you the Fed will increase interest rates to slow things down and growth can proceed at a calmer, steadier pace. When the economy is flagging, the Fed will lower rates because lower borrowing costs will encourage consumers to borrow and businesses to invest more in their businesses (the cost to borrow has suddenly become cheaper).
Why Bonds Appreciate
There are two main reasons bonds appreciate, meaning price increases beyond what you paid for it.
The first we already covered – changes in interest rate lead investors to either discount and add a premium to bonds already on the market such that the yield on those investments gets close to the yield on newly issued bonds.
The second is the perceived security of that X% return compared to other options to deploy capital.
You may see a headline on Bloomberg like “Investors flock to safety of bonds after Brexit vote”. It’s not that the 2% yield on corporates bonds changed overnight. It was that all of a sudden, looking at what could be a global recession impacting what they could get in other asset classes, that 2% looked a lot more attractive than before. Thus, investors bid up the price for them.
You also saw Greek bonds drop in face value. While bonds are generally perceived as safer as a class than other assets, extenuating circumstances may cause a bond’s price to decrease because investors believe it to be riskier than other options. Bondholders thought there was a good chance Greece defaulted on the loans they had issued (and for good reason: the country had basically announced that it had no way to pay them). Because of that, the bonds depreciated in value to a significant degree.
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