Have you heard, watched, or read news regarding The Fed and/or Interest Rate Cuts recently? Here’s what you need to know.
Current predictions lead us to expect a cut in September and— if inflation and employment rates are kept near 2% and 5%, respectively, more to follow for the next several years.
As we prepare for September, it’s important to understand the historical correlations that exist between interest rates and bonds and the impacts that will be felt by, in this article’s case… the bond market.
A quick refresher on Bonds: You’re the lender. Your money is borrowed. In exchange, you’re paid back the Face Value of your original investment with interest at an annualized % decided by the Coupon Rate over a specified time period called Maturity or the Expiration Date.
For example, let’s say you decide to purchase a 20 Year Treasury Bond with a Face Value of $1000 at a 5% Coupon Rate.
The Fed then decides to cut interest rates by 1% and 20 Year Treasury Bond rates drop to 3%.
Not to worry, you’re still earning 5%.
However, because 5% is no longer an option for the rest of us Non-Long-Term-Bond-Owners, your Bond is now valuable, and therefore, can be sold at a premium, granting you quicker cash and a higher annualized return in exchange for your suddenly rare stream of fixed-income.
When Interest Rates Drop. Bond Prices Rise. And Vice Versa.
Bonds also have tax benefits. Treasury Bonds are exempt from Federal, but not State or Local, while Municipal Bonds are exempt from all taxes.
To find the Tax Equivalent Yield, use: y / (1 – x) when y = Taxable Yield and x = Tax Bracket.
Another way to invest in bonds is through Exchange-Traded Funds (ETFs) or Mutual Funds. TLT (iShares 20+ Year Treasury Bond ETF) allows you to invest in $60B+ of long-term bonds at around $90 per share.
The advantage of long-term bonds in our case is that they’re sold at higher premiums when interest rates decline relative to intermediate/short-term bonds.
If you are looking for ways to invest and are expecting interest rates to fall, buy real estate. However, if like the vast majority of Americans, you can’t afford it, investing in bonds directly or through Mutual Funds/ETFs seems to me like a smart, safe, and effective alternative.