Revisiting Bonds: The interest rate conundrum
The Federal Reserve’s recent attempt to tame inflation has resulted in a sharp decline in bond prices. The current situation is incredibly unique. Through May 31, 2022, core bonds, as represented by the Bloomberg US Aggregate index, have fallen over 10%the largest fall coincident with a market selloff since at least 1962i. To better understand the complexity of the current situation, let’s start with why bond prices decline.A bond purchase is similar to making a loan to a corporation or a government entity. A bond held till maturity pays interest (also known as a coupon) periodically and returns principal on the maturity date. Let’s assume the coupon rate of a bond is 3%. When interest rates rise, new bonds will be issued with a higher coupon rate, which means the old bond with the 3% coupon is now less desirable. For the old bond to be attractive to investors, it must be priced at a discount. This causes existing bond holders to see price declines when interest rates rise.