How are bonds affected by the Federal Funds Rate?

Question

My question is how do bonds react to changes in the Federal Funds Rate? Specifically, government bonds, because I don't see corporate bonds being affected as drastically. I've done research, but for some reason it's not clicking with me.

I'm planning on starting my Roth IRA account, and probably will do 95% equities for now since I'm 23... but I still think I should consider buying some bonds. Since the FFR is so low, and I sense the Fed will raise their target sometime soon, I'm deciding whether I should hold off on buying bonds for now, or if now is a good time. Thanks!

Answer 1

I'll answer your question, but first a comment about your intended strategy. Buying government bonds in a retirement account is probably not a good idea. Government bonds (generally) are tax advantaged themselves, so they offer a lower interest rate than other types of bonds. At no tax or reduced tax, many people will accept the lower interest rate because their effective return may be similar or better depending, for example, on their own marginal tax rate. In a tax-advantaged retirement account, however, you'll be getting the lower interest without any additional benefit because that account itself is already tax-advantaged. (Buying bonds generally may be a good idea or not - I won't comment on that - but choose a different category of bonds.)

For the general question about the relationship between the Fed rate and the bond rate, they are positively correlated. There's not direct causal relationship in the sense that the Fed is not setting the bond rate directly, but other interest bearing investment options are tied to the Fed rate and many of those interest-bearing options compete for the same investor dollars as the bonds that you're reviewing. That's at a whole market level. Individual bonds, however, may not be so tightly coupled since the creditworthiness of the issuing entity matters a lot too, so it could be that "bond rates" generally are going up but some specific bonds are going down based on something happening with the issuer, just like the stock market might be generally going up even as specific stocks are dropping.

Also keep in mind that many bonds trade as securities on a secondary market much like stocks. So I've talked about the bond rate. The price of the bonds themselves on the secondary market generally move opposite to the rate. The reason is that, for example, if you buy a bond at less than face value, you're getting an effective interest rate that's higher because you get the same sized incremental payments of interest but put less money into the investment. And vice versa.

Answer 2

The federal funds rate is one of the risk-free short-term rates in the economy. We often think of fixed income securities as paying this rate plus some premia associated with risk.

For a treasury security, we can think this way:

(interest rate) = (fed funds rate) + (term premium)

The term premium is a bit extra the bond pays because if you hold a long term bond, you are exposed to interest rate risk, which is the risk that rates will generally rise after you buy, making your bond worth less. The relation is more complex if people have expectations of future rate moves, but this is the general idea. Anyway, generally speaking, longer term bonds are exposed to more interest rate risk, so they pay more, on average.

For a corporate bond, we think this way:

(interest rate) = (fed funds rate) + (term premium) + (default premium)

where the default premium is some extra that the bond must pay to compensate the holder for default risk, which is the risk that the bond defaults or loses value as the company's prospects fall.

You can see that corporate and government bonds are affected the same way (approximately, this is all hand-waving) by changes in the fed funds rate.

Now, that all refers to the rates on new bonds. After a bond is issued, its value falls if rates rise because new bonds are relatively more attractive. Its value rises if rates on new bonds falls. So if there is an unexpected rise in the fed funds rate and you are holding a bond, you will be sad, especially if it is a long term bond (doesn't matter if it's corporate or government). Ask yourself, though, whether an increase in fed funds will be unexpected at this point. If the increase was expected, it will already be priced in. Are you more of an expert than the folks on wall-street at predicting interest rate changes? If not, it might not make sense to make decisions based on your belief about where rates are going. Just saying.

Brick points out that treasuries are tax advantaged. That is, you don't have to pay state income tax on them (but you do pay federal). If you live in a state where this is true, this may matter to you a little bit. They also pay unnaturally little because they are convenient for use as a cash substitute in transactions and margining ("convenience yield"). In general, treasuries just don't pay much. Young folk like you tend to buy corporate bonds instead, so they can make money on the default and term premia.