Bonds and Interest Rates
Bonds are debt securities issued by governments and corporations to fund their operations. Investors can purchase bonds from the issuer, who is then required to make interest payments on a regular schedule over a set number of years. (This is why bond funds are also known as fixed income investments.) The amount of interest paid reflects the prevailing interest rate environment at the time of issuance and is fixed over the life of the bond.
Fixed Income Funds
Actively managed fixed income mutual funds can invest in bonds, notes and other securities issued by governments and corporations in the US and almost any country in the world. The funds’ specific investments can vary widely, based on the types of securities they are permitted to own. For example:
- Some funds are limited solely to US government securities, which are considered the highest quality, as the US has never defaulted on its debt.
- Other funds may invest in US corporate debt, or the debt of foreign governments or companies, which may be of lower quality.
Bond Prices, Coupons, and Yields
Regardless of whether a bond is issued by a government or a corporation, the mechanics of bond pricing are the same. Bonds are issued at a specific rate of interest they will pay to investors, known as the coupon. Once issued, the coupon never changes – but prevailing interest rates can. When that happens, an existing bond’s coupon rate may become more or less attractive by comparison, and that affects its price.
- When an existing bond has a higher coupon than a newly issued bond, it pays out more income. Investors may be willing to pay more to own it, so its market price would go up.
- Conversely, when an existing bond has a lower coupon than current rates, investors may find it less appealing, and its market price would go down.
As Bond Price Declines, Yield Increases
Understanding the relationship between bond prices and yields helps explain why bond investors can lose money based on the current price of their bonds, even though the interest income may help offset some of the price decline. When interest rates rise, prices of existing bonds tend to fall, even though the coupon rates remain constant: Yields go up. Conversely, when interest rates fall, prices of existing bonds tend to rise, their coupon remains constant – and yields go down.
A Note About Quality
Not surprisingly, a bond’s quality also has direct bearing on its price and yield. Bonds are rated by independent agencies, with AAA/Aaa to BBB/Baa considered “investment grade.” These higher-quality bonds generally have a lower yield than non-investment-grade or non-rated securities, because they are considered more likely to make all of their scheduled interest payments. Conversely, lower-rated (“high yield”) bonds pay higher coupon rates because there is a greater possibility that the issuer could default and fail to make payments.
Choosing the Right Bond Fund
With so many variables to consider, most financial advisors recommend actively managed fixed income mutual funds for their clients rather than individual bonds or ETFs. Active bond funds have the benefits of experienced professional managers, a specified investment objective, diversification, and daily liquidity.
Be sure to reach out to your financial advisor to discuss the right mix of fixed income investments for you. Depending on your age, risk tolerance, and overall income needs, your advisor can help you maintain an appropriate level of income diversification in your portfolio.
Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.
Mortgage-related and asset-backed securities are subject to the risks of the mortgages and assets underlying the securities. Other related risks include prepayment risk, which is the risk that the securities may be prepaid, potentially resulting in the reinvestment of the prepaid amounts into securities with lower yields.
Below investment grade fixed income securities may be subject to greater risks (including the risk of default) than other fixed income securities.
Foreign and emerging market securities may be subject to greater political, economic, environmental, credit, currency and information risks. Foreign securities may be subject to higher volatility than US securities, due to varying degrees of regulation and limited liquidity. These risks are magnified in emerging markets.
Currency exchange rates between the US dollar and foreign currencies may cause the value of the fund's investments to decline.
Inflation protected securities move with the rate of inflation and carry the risk that in deflationary conditions (when inflation is negative) the value of the bond may decrease.
Before investing, consider the fund's investment objectives, risks, charges, and expenses. You may obtain a prospectus or a summary prospectus containing this and other information. Read it carefully.
Natixis Distribution, L.P. is a limited purpose broker-dealer and the distributor of various registered investment companies forwhich advisory services are provided by affiliates of Natixis Investment Managers.
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