If considering investing in fixed income securities, such as bonds or taking out another form of fixed income investment, then an understanding of the relationship between interest rates and a fixed income is key.
The relationships considered here assume that an individual has purchased a bond for the purposes of obtaining a fixed income investment, rather than as a security to be traded in the secondary market for capital gains.
Fixed Incomes Investments: The Relative Value of Bonds When Interest Rates Rise
When interest rates rise, the relative value of a bond will fall in the eyes of the fixed income investor. For example, if a bond was purchased with a coupon rate of 4% and the current base rate of interest sees the investor only able to achieve 3% on a savings account, one can see that the bond is an attractive option.
However, should interest rates rise and the average savings account subsequently pays out 5%, then the consideration is that the bond investor is tied to a fixed income investment, which is 1% below the rate which could have been achieved now that interest rates have risen. As such, the relative value of the investment in bonds has declined as interest rates have risen.
Fixed Income Securities: The Relative Value of Bonds When Interest Rates Fall
Using the same example, should interest rates fall and the rate of interest achievable on a savings account subsequently fall to 2%. The consideration is that the investor in bonds will still receive 4% which is 2% more than they could achieve by investing in a savings account.
As such, when interest rates fall the relative value of a fixed income investment, such as bonds rise in relation to alternative investment options. This is despite the fact that the actual or nominal level of income received will remain the same. In both of the examples given it is important to note that it is only the relative value of the investment which changes for the bond holder, in both cases the actual amount of income received will remain the same and is based upon the coupon rate of the bond.
In summary, assuming that a high quality bond has been invested in and the bond is held to maturity, the major advantage is one of stability. Here the investor knows the exact nominal fixed income they will receive each period, regardless of interest rates. However, on the downside the relative or real value of the fixed income will fluctuate in relation to alternative investment options, dependent on the movement of interest rates as issued by the central bank.
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Frank Smith - Frank Smith currently works as an full time industry analyst for a well known construction company in Lincolnshire. In his spare time, ...
