If you are holding a fixed-income bond and the Federal Reserve engineers a rise in market interest rates, what will happen to the value of your bond?
A the value of the bond will increase.
B the value of the bond will decrease.
C the value of the bond will be unaffected.
The correct answer and explanation is:
The correct answer is B: The value of the bond will decrease.
When the Federal Reserve raises market interest rates, the value of existing fixed-income bonds typically decreases. This happens due to the inverse relationship between interest rates and bond prices. Here’s why:
Bonds are fixed-income securities, which means they pay a predetermined interest (coupon) rate to bondholders. When you purchase a bond, you are agreeing to receive interest payments at that fixed rate for the life of the bond. The price you pay for the bond is influenced by the prevailing market interest rates.
If the Federal Reserve raises interest rates, newly issued bonds will offer higher coupon rates to attract investors. For example, if market rates rise from 3% to 4%, newly issued bonds will pay 4% interest. However, if you are holding a bond that was issued when rates were lower (e.g., 3%), the bond with the 3% coupon is now less attractive to investors. This is because investors can buy the new bonds paying 4% interest, and the older bonds paying 3% will seem less appealing.
To compensate for the lower coupon rate, the price of the older bond will fall in the secondary market. This price drop brings the yield (the effective return on the bond) in line with current market rates. The bond’s price adjusts so that its yield is competitive with newly issued bonds that offer higher rates. Therefore, as interest rates rise, the value of existing bonds falls.
The decrease in bond value is more pronounced for bonds with longer durations or maturities. This is because long-term bonds are more sensitive to interest rate changes than short-term bonds, as they lock in the fixed coupon rate for a longer period.
In conclusion, when the Federal Reserve raises interest rates, the value of your bond decreases, as newer bonds with higher rates make your existing bond less attractive to investors.