Dolf Dunn Wealth Management, LLCDolf Dunn, CPA/PFS,CFP®,CPWA®,CDFA

Private Wealth Manager11330 Vanstory Drive

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Bonds, Interest Rates, and the Impact of Inflation

September 30, 2013

There are two fundamental ways that you can profitfrom owning bonds: from the interest that bonds pay,or from any increase in the bond's price. Many peoplewho invest in bonds because they want a steadystream of income are surprised to learn that bondprices can fluctuate, just as they do with any securitytraded in the secondary market. If you sell a bondbefore its maturity date, you may get more than itsface value; you could also receive less if you mustsell when bond prices are down. The closer the bondis to its maturity date, the closer to its face value theprice is likely to be.

Though the ups and downs of the bond market arenot usually as dramatic as the movements of thestock market, they can still have a significant impacton your overall return. If you're considering investingin bonds, either directly or through a mutual fund orexchange-traded fund, it's important to understandhow bonds behave and what can affect yourinvestment in them.

The price-yield seesaw and interestratesJust as a bond's price can fluctuate, so can itsyield--its overall percentage rate of return on yourinvestment at any given time. A typical bond's couponrate--the annual interest rate it pays--is fixed.However, the yield isn't, because the yield percentagedepends not only on a bond's coupon rate but also onchanges in its price.

Both bond prices and yields go up and down, butthere's an important rule to remember about therelationship between the two: They move in oppositedirections, much like a seesaw. When a bond's pricegoes up, its yield goes down, even though the couponrate hasn't changed. The opposite is true as well:When a bond's price drops, its yield goes up.

That's true not only for individual bonds but also thebond market as a whole. When bond prices rise,yields in general fall, and vice versa.

What moves the seesaw?In some cases, a bond's price is affected bysomething that is unique to its issuer--for example, achange in the bond's rating. However, other factorshave an impact on all bonds. The twin factors thataffect a bond's price are inflation and changinginterest rates. A rise in either interest rates or theinflation rate will tend to cause bond prices to drop.Inflation and interest rates behave similarly to bondyields, moving in the opposite direction from bondprices.

If inflation means higher prices, whydo bond prices drop?The answer has to do with the relative value of theinterest that a specific bond pays. Rising prices overtime reduce the purchasing power of each interestpayment a bond makes. Let's say a five-year bondpays $400 every six months. Inflation means that$400 will buy less five years from now. Wheninvestors worry that a bond's yield won't keep up withthe rising costs of inflation, the price of the bonddrops because there is less investor demand for it.

Why watch the Fed?Inflation also affects interest rates. If you've heard anews commentator talk about the Federal ReserveBoard raising or lowering interest rates, you may nothave paid much attention unless you were about tobuy a house or take out a loan. However, the Fed'sdecisions on interest rates can also have an impacton the market value of your bonds.

The Fed takes an active role in trying to preventinflation from spiraling out of control. When the Fedgets concerned that the rate of inflation is rising, itmay decide to raise interest rates. Why? To try toslow the economy by making it more expensive toborrow money. For example, when interest rates onmortgages go up, fewer people can afford to buy

The inflation/interest ratecycle at a glance

• When prices rise,bondholders worry thatthe interest they're paidwon't buy as much.

• To control inflation, theFed may raise interestrates to get investors topurchase bonds.

• When interest rates goup, borrowing costs rise.Economic growth andspending tend to slow.

• With less demand forgoods and services,inflation levels off orfalls. Bond investorsworry less about thebuying power of futureinterest payments. Theymay accept lowerinterest rates on bonds,and prices of olderbonds with higherinterest rates tend torise.

• Interest rates in generalfall, fueling economicgrowth and potentiallynew inflation.

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Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2013

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for anyindividual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performancereferenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The tax information provided is not intended to be a substitute for specific individualized tax planning advice. We suggest that you consult with aqualified tax advisor.

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homes. That tends to dampen the housing market,which in turn can affect the economy.

When the Fed raises its target interest rate, otherinterest rates and bond yields typically rise as well.That's because bond issuers must pay a competitiveinterest rate to get people to buy their bonds. Newbonds paying higher interest rates mean existingbonds with lower rates are less valuable. Prices ofexisting bonds fall.

That's why bond prices can drop even though theeconomy may be growing. An overheated economycan lead to inflation, and investors begin to worry thatthe Fed may have to raise interest rates, which wouldhurt bond prices even though yields are higher.

Falling interest rates: good news, badnewsJust the opposite happens when interest rates arefalling. When rates are dropping, bonds issued todaywill typically pay a lower interest rate than similarbonds issued when rates were higher. Those olderbonds with higher yields become more valuable toinvestors, who are willing to pay a higher price to getthat greater income stream. As a result, prices forexisting bonds with higher interest rates tend to rise.

Example: Jane buys a newly issued 10-yearcorporate bond that has a 4% coupon rate--that is, itsannual payments equal 4% of the bond's principal.Three years later, she wants to sell the bond.However, interest rates have risen; corporate bondsbeing issued now are paying interest rates of 6%. Asa result, investors won't pay Jane as much for herbond, since they could buy a newer bond that wouldpay them more interest. If interest rates later begin tofall, the value of Jane's bond would riseagain--especially if interest rates fall below 4%.

When interest rates begin to drop, it's often becausethe Fed believes the economy has begun

to slow. That may or may not be good for bonds. Thegood news: Bond prices may go up. However, aslowing economy also increases the chance thatsome borrowers may default on their bonds. Also,when interest rates fall, some bond issuers mayredeem existing debt and issue new bonds at a lowerinterest rate, just as you might refinance a mortgage.If you plan to reinvest any of your bond income, itmay be a challenge to generate the same amount ofincome without adjusting your investment strategy.

All bond investments are not alikeInflation and interest rate changes don't affect allbonds equally. Under normal conditions, short-terminterest rates may feel the effects of any Fed actionalmost immediately, but longer-term bonds likely willsee the greatest price changes.

Also, a bond mutual fund may be affected somewhatdifferently than an individual bond. For example, abond fund's manager may be able to alter the fund'sholdings to minimize the impact of rate changes. Yourfinancial professional may do something similar if youhold individual bonds.

Focus on your goals, not on interestrates aloneThough it's useful to understand generally how bondprices are influenced by interest rates and inflation, itprobably doesn't make sense to obsess over what theFed's next decision will be. Interest rate cycles tend tooccur over months and even years. Also, therelationship between interest rates, inflation, andbond prices is complex, and can be affected byfactors other than the ones outlined here.

Your bond investments need to be tailored to yourindividual financial goals, and take into account yourother investments. A financial professional can helpyou design your portfolio to accommodate changingeconomic circumstances.

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