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Tuesday, March 14, 2017

What Happens to Bond Funds When Interest Rates Go Up?

Bonds, on average, will decline when interest rates rise. In the capital markets, this is a common inverse relationship. Why?
Back to the fundamentals of Economic thought..
The true notion of interest rates is based on the time preference of consumers in the marketplace: The ratio of prices is based on consumption of goods in the present vs consumption in the future. If this ratio is lower, consumption is preferred in the present, conversely, if higher, then consumption is preferred in the future.
A bond is simply a debt instrument. It allows firms, or Govts, to raise capital, to wit, borrow the money, to expand operations. Investors will purchase these financial instruments to obtain a certain fixed percentage yield from the bond, as this income payout takes place until the maturity of the bond.
Since the bond yield is fixed, as it pays an income stream over time, if the interest rate rises, investors simply want to seek other investment opportunities away from bonds that will yield a better ROI. If the interest rate is lower, the fixed income stream, from the bond, works better, for the investor, in a lower interest rate environment.
In a lowered interest rate environment, capitalists will seek to acquire more equipment, spend more money to invest in their business, expand operations, and etc. This activity includes the intense purchase of bonds, as they are a means of raising capital.
This marvelous ebb and flow interplay between Bonds and interest rates creates arbitrage opportunities for investors, as interest rates rise and fall.
This quick analysis is an introduction into the notion of business cycle theory, as interest rates play a vital role in this process.

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