How are Savings Bonds Affected by the Economy?
Technology has made our lives easier and allowed us to be more productive at work. In addition, tech has transformed most sectors around the globe and led to many industries undergoing something of a digital revolution lately.
A good example of this is the investment sector, which now allows people to trade from home via the Internet at online investment brokers. One popular asset which people like to put money into is savings bonds. These essentially result in traders loaning money to national governments by buying bonds the governments issue.
The investor not only gets their initial outlay back when the loan period is up, but they also receive regular interest payments on the loan. Before you invest in this asset though, it is key to know how it can be impacted by the economy.
So, what economic factors can have an influence on savings bonds?
One of the most important economic factors which can impact this asset is inflation. This is because inflation can negatively impact the return you receive when the bond matures and the money you loaned out is paid back. High inflation can also be an issue for the economy in general and lead to people having to find ways to cut back on utility bills, save cash on shopping, and generally make their money stretch further than before.
Although investing in the most highly rated bonds almost guarantees you will get your initial capital outlay back, high inflation over the course of the investment could result in you not making as much profit as you hoped.
But how does this work in practice? Inflation is simply when the prices of goods/services in an economy rise and purchasing power declines. Rising inflation can lead to returns on bonds being reduced to take this into account and to reflect the damage inflation does to the bond’s future cash flow.
If you invest in a fixed-rate bond over a longer term, inflation can be especially dangerous and important to consider. If the bond is due to pay a 5% yield at a fixed interest rate, but inflation is 4%, then the real return you would receive is only 1%.
Also read: Personal Finance For Young Matures: Stocks Vs. Bonds
It is widely accepted that bonds have an inverse relationship with interest rates. This means that when interest rates rise the value of bonds drops and vice versa. It is therefore easy to see how changes to interest rates by central banks can impact the value of bonds you might hold. Although this might not be a major issue for people holding fixed-rate bonds who plan to hold onto their asset until it matures, it can be more pertinent for other investors.
If you are holding a variable rate bond that is due to mature soon, for example, a sudden drop in interest rates could result in your bond being worth more when redeemed. A sudden rise in rates though could actually cause the opposite to happen!
Interest rate changes can also have an impact on any return if you redeem your bond early. This is because you will redeem the bond at the current interest rate, which will impact the return you receive.
One other thing to note for investors is the connection interest rates have with inflation. Central banks will often use them as a way of maintaining control over inflation. An economy that is overheating through rising inflation for example may lead to rising interest rates to help combat this. If you plan to invest in bonds, it is key to know about this relationship and how inflation could cause changes to interest rates which impact their value.
Poor economic performance hits bond values
While inflation and interest rates are two key parts of an economy that can impact the value of savings bonds, the general economic performance of a country can also have an influence. This is due to the potential credit risk a tanking economy poses to those who have invested in bonds from the country in question.
In simple terms, a poor economic state in the country that issued the bonds could lead to them not making interest payments, or not being able to cover the principal payment at the end of the loan term.
If this situation occurs, the bond’s price will be negatively affected due to this perceived credit risk and interest rates will probably also rise in the country affected in an attempt to salvage their economy. It must be said that credit risk associated with bonds is unlikely if you stick to investing in bonds from the biggest, most developed nations.
Bond value linked to the national economy
As the above shows, it is true that the value of savings bonds can be impacted by various economic factors which the country that issues them might be dealing with. As an investor, it is key to understand them and how they might impact the value of bonds you hold.