Interest rate movements are a central factor affecting financial investments across the board. The Federal Reserve controls its federal funds rate which serves as the foundation for interest rate movements. Its goals are to use the rate to impact the economy through management of the cost of credit, particularly for businesses. When interest rates are lowered, companies can access credit with a lower cost, including the costs of bond issuances. When interest rates rise the cost of credit increases for borrowers. The Fed’s control of the federal funds rate impacts federal funds on loan as well as Treasuries, which are the safest bond investments for investors in the market.

Key Takeaways

  • In the bond market, prices fall when rates rise and vice versa.
  • Supply and demand in the secondary market for bonds can be an added factor that causes bonds to trade away from their theoretical value.
  • Junk bonds are subject to the same mechanisms as all other types of bonds though the higher risks associated with junk bonds can have an affect on their trading value in different rate environments.

The Fed has been announcing its federal funds rate targets since 1979. The chart below shows the history of the federal funds rate which has been associated with the Federal Open Market Committee’s economic strategies and the overall interest rate environments for the financial markets.

Historical Federal Funds Rate
Historical Federal Funds Rate.

Source: MacroTrends

The federal funds rate is only the base rate for the market’s interest environment. As such, it often forms the underlying foundation for interest rate movements but it is only a base. In general, there are five major categories of bonds:

  • Treasuries
  • Municipals
  • High quality corporate bonds
  • Intermediate quality corporate bonds
  • High yield (junk) corporate bonds

While they are different, they are all created from the same fundamentals. Borrowers (governments, government agencies, and companies) issue bonds as a credit instrument. Investors pay a specified value in return for coupon and interest payments. Each bond has its own rate which determines the amount of a coupon the investor receives and the amount of interest received with a principal. These basics are also the framework for valuing bonds. A bond’s value is calculated by discounting future payments of coupon and principal plus interest to the present value using the bond’s interest rate as the discounting factor.

At the time of issuance, a bond’s value is known as face value. This is the value at the time of issuance in the primary market. Fundamentally, according to bond valuation mechanics, when interest rates rise the bond’s value will fall because the discount rate is increasing. When interest rates fall, the bond’s value will rise because the discounting factor is decreasing. However, using the fundamentals only provides a theoretical value. The valuation methodology does not take into consideration the trading supply and demand in the secondary market which is where bond values actual fluctuate on a daily basis.

The Federal Reserve’s positioning on the federal funds rate is only a base. It will have a big influence on Treasuries, but as bond’s move up the risk spectrum, the influence becomes somewhat diluted since each market has its own characteristics.

Junk Bonds

High-yield, or so-called junk bonds, are a profitable opportunity for investors looking to take on the highest levels of risk available in the bond market. Though high-yield bonds clearly require a significant amount of research beforehand due to their higher risk, if investors can perform such due diligence, interesting risk-return trade off opportunities exist.

Junk bonds get their name because they are the lowest rated corporate bonds in the market, which in turn is why they require such a high interest rate to solicit any investors.

The ICE BofAML US High Yield Master II Effective Yield Index is one of the market’s barometers for the returns an investor can expect from high yield bonds.

Historical High Yield Returns
Historical High Yield Returns.

Let’s dive a little deeper into where these yields come from.  Generally like mentioned above, the coupon rate is the key component that determines the rate of interest return an investor can expect.

Coupon rate: The issuer determines the coupon interest rate at the time of issuance. Once determined, the borrower promises to pay investors the coupon interest rate at specified intervals as well as the designated interest rate on the principal payment at maturity.

The issued coupon rate helps to make a bond equal to its face value at issuance. However, over the bond’s life, companies with the same rating may issue new debt at higher or lower rates. The supply and demands for junk bonds in the secondary market may also fluctuate. This makes the current issuance rate different than the coupon rate of an already issued bond and that’s where price fluctuations can come in.

As discussed, when interest rates in a particular bond market category are rising, prices should theoretically fall and vice versa. However, the supply and demand for those bonds in the secondary market doesn’t not always follow the theoretical price or lead to the same theoretical changes. Thus, prices are expected to fall when rates rise but there is no guarantee. Other factors, like risk appetite for other asset classes can also affect junk bond prices. In general, higher demand for junk bonds raises the price and lowers the yield while lower demand lowers the price and increases the yield. These effects work alongside the basic fundamentals to produce the values investors see on the price quotes.

Maturity: A second important factor to consider when investing in bonds is the maturity. For junk bonds and all bonds in general, the longer the maturity, the higher the risk of price and yield changes. In a dovish interest rate environment rates will be falling and in a hawkish environment rates will be rising. Shorter term maturities can more easily reset while longer term investors are stuck in their investment for the long haul. This means longer term investors have the most to lose when rates are rising because the values of their investments are falling and they don’t have the opportunity to get in at the higher rate since they are already locked in at the lower rate they agreed on. If they choose to sell, they receive a lower price for what they already own mitigating the benefits of replacements.

In the bond market, there are two advanced terms that can be very important: convexity and duration. While these two terms are advanced concepts, they are the next step for investors in quantifying exactly how much risk they have based on the interest rate and maturity levels they are locked in at.

Coupon rates and maturity time frames are two very important factors in determining pricing affects of all bonds and junk bonds in particular.

How to Play Rate Changes

Junk bonds offer the bond market’s highest potential yields along with the highest potential risks. When rates are rising, getting into new issuances at higher rates offers a higher rate of return. This also means the junk bonds you may hold already become less valuable. Vice versa, when rates are falling, any junk bonds you already hold will increase in value but new ones you may buy will offer a lower return.

Longer maturities come with higher rates of interest but also higher risk because of the fluctuations that can happen while holding the bonds. If you are a cautious investor staying with shorter term maturities in the junk bond market can help you reap any higher yields available in a rising rate environment while also maintaining control of the rates you’re earning when the maturities roll over.

Many investors would rather put the decision making into the hands of a professional which is where high yield bond funds come in. Investopedia suggests the following five high yield bond funds for investors in 2020:

  1. Fidelity Capital & Income Fund (FAGIX)
  2. Vanguard High-Yield Corporate Fund Investor Shares (VWEHX)
  3. BlackRock High Yield Bond Fund (BHYCX)
  4. SPDR Bloomberg Barclays High Yield Bond ETF (JNK)
  5. iShares iBoxx $ High Yield Corporate Bond ETF (HYG)

With these funds and the many others available you will get a diversified portfolio of high yield bonds with a variety of coupons and maturities. You can generally expect to see higher returns when rates are falling since existing holdings will yield more. When rates are rising managers may buy and sell more often to seek out the best rates but in general a portfolio’s holdings will usually fall in value due to discounting and the fact that  newer issuance is offering a higher return than what exists in the portfolio already.

The Bottom Line

In the bond market, generally bond prices fall when rates rise and bond prices rise when rates fall. These effects are based on theoretical calculations for the pricing of bonds. While this is the theory and typically holds true, there is supply and demand in the secondary markets that can make rate change effects more or less dramatic for secondary market investors.

The mechanisms of bond pricing effect all types of bonds in the same way. Junk bonds are no different, subject to the methodologies of valuation that guide the market’s pricings. Junk bonds are generally known to be the highest yielding investments available in the bond market. Investors will find that the actual effects of changing interest rates in the junk bond category may be less dramatic than say Treasuries. This is because rate changes usually become more subtle as you rise in the risk spectrum. Coupon rates and maturities play a part in the investment opportunity but so does the market’s perceptions of rate changes and the demands that can be swayed by appetite for other types of asset classes.