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When dealing with bonds and interest rates, it is essential to know that they go hand in hand. There is an inverse relationship that bonds have to interest rates. When the price of borrowing money increases, bond prices decrease and work the other way around as well. Many bonds will pay a fixed interest rate that becomes more beneficial when interest rates drop. This will then spike the demand of the interest rate, thus increasing the cost of the bond. However, if interest rates start to rise, investors start to become less attracted to the lower fixed interest rate that was being paid by the bond, which then cuts down its price. Below we will take a deeper look at some of the correlations between bond prices and interest rates, as featured in an article on Investopedia .
Bond Prices vs. Yield
Just like all investors, bond investors’ primary goal is to receive the best return possible. In order to achieve this, they have to constantly keep themselves in the know of the costs of borrowing, which fluctuates often. Understanding zero-coupon bonds will help you to grasp the concept of bond prices traveling in the direction opposite of interest rates. Yield is a function of the purchase price of zero-coupon bonds. However, zero-coupon bonds help lock in the bond yield, which is a very beneficial situation for investors.
Bond Prices vs. The Fed
The “fed” refers to the national interest rate or the federal funds rate set and regulated by the Federal Open Market Committee. This is vastly used as a basis for the interest rates on various debt securities and investments. When the Fed increases interest rates, the bond market decreases. With Covid19 having a significant impact on the economy, many investors are staying close to the safety net of government-issued bonds.
Zero-coupon bonds tend to be quite volatile, and for this reason, they do not pay periodic interest throughout the bond’s lifespan. However, zero-coupon bonds have interesting tax implications. Although there is no periodic interest being spent on the bond, the annual accumulated interest is labeled as income, which is then taxed as interest. Annual taxes must be paid on this bond even though investors do not gain any money until the bond is fully mature. Zero-coupon bonds tend to be somewhat frustrating for investors.
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Originally published at https://kristianfinfrock.org.