I reviewed a key investing concept with a client this week and thought it was worth highlighting it here as well. The concept? The inverse relationship between interest rates and bond prices.

Bonds (also known as fixed income securities) are a type of investment held in most portfolios. Bonds are a contractual promise made by a borrower to repay funds loaned by an investor, plus a stated rate of interest, for a given term. Bonds are issued by a variety of parties to raise capital, commonly including the US government, other governments around the world, corporations, and municipalities.

Bond’s alternate name of “fixed income” comes from the fact that bonds include the specified rate of interest to be paid over the bond term. Barring any credit challenges for the issuer, the income (ie: interest) paid from the bond during its term is known – ie: fixed.

This knowable income stream and contractual promise to repay has made bonds an important part of portfolios as there is a knowable upside (the interest to be paid) and a limited downside (provided the issuer stays in sound financial health, the principal will be repaid upon maturity).

However, one key feature of bonds that investors may overlook is that once they are issued, the price or fair value of the bond will change minute-by-minute as the prevailing interest rates in the market change. If you plan to hold an individual bond until its maturity date, you will receive your principal back and the contractually stated interest over the bond term. But if you wish to buy/sell a bond in the middle of its term – or if you own a bond fund that does just that – you need to pay attention to the likely path of rates. This is due to the inverse relationship between bond prices and interest rates.

Bond prices go up as market rates go down (and vice versa). Why is this the case? I think it’s easiest to grasp this concept with an example.

Let’s assume a company needs $1000. They issue you a bond today and agree to pay you 5% interest (the current market rate) for a two-year period. If you hold this bond for the full term, you will earn $100 in interest ($1000*5%*2 years).

Three months later, the interest rate is now 4%. A friend of yours is interested in buying a bond from the same company. An identical bond issued three months later (at the lower rate) would earn $80 in interest over the same term. This change in rates makes the bond you hold (that was issued at 5%) more valuable.

If your friend wanted to buy this bond from you, you’d be able to charge more than the $1000 you paid for it (called a premium) due to the fact that your bond entitles the bond holder to a stream of interest payments above the current prevailing rate.

In practice, this dynamic will appear in the price listed for your bond during its life in your account. This change in the underlying fair value of your bond plus the interest earned makes up the total return on your bond during your holding period.

In today’s environment, with the likely path of rates to the downside (as inflation cools and the fed lowers the short-end of the curve), it’s reasonable to assume that the value of already issued fixed income securities may rise in the coming months/years, adding to their total return picture.

As always, the exact type of fixed income security and the suggested allocation depends on your individual investment portfolio and objectives. Work with your advisor to determine your strategy – but always keep the inverse relationship between price and rates in mind.