How are short- and long-term interest rates different?
The Federal Reserve Board controls the federal funds rate. The Federal Reserve Board (Fed) has the power to raise or lower the federal funds target rate (Fed funds rate), which in turn influences the market for shorter-term securities. The Fed funds rate is the rate banks charge other banks for overnight loans. The Fed may raise the rate to keep inflation in check or lower it to stimulate the economy.
Long-term rates are market driven. Long-term interest rates, as represented by yields of the 10-year or 30-year Treasury bond, tend to move in anticipation of changes in the economy and inflation.
What causes interest rates to rise and fall?
Economic factors influence interest rates. Both short- and long-term interest rates are affected by economic factors such as inflation, the strength of the U.S. dollar and the pace of economic growth.
For example, if the economy seems to be slowing, the Fed may lower the Fed funds rate to stimulate economic growth, as we witnessed from September 2007 to April 2008.
On the other hand, strong economic growth can lead to inflation. If the Fed becomes concerned about inflation, it may attempt to cool the economy by raising the Fed funds rate, as it did in 2004 and 2005.
Economic factors also affect long-term interest rates. For example, over the summer of 2003 and then again in the spring of 2004, long-term interest rates rose as the economy showed signs of strength.
As illustrated below, short- and long-term interest rates don't necessarily move in tandem. While short-term rates rose substantially from 2004 through 2006, long-term rates, despite some fluctuations, experienced only a slight increase.
Interest Rates1
10-Year Period Ended September 30, 2008
- Sources: Federal Reserve and Bloomberg, as of 9/30/08
How do interest rates affect bond prices?
Interest rates and bond prices have an inverse relationship. As illustrated below, when interest rates rise, bond prices generally fall. Conversely, when interest rates decline, bond prices tend to rise.
Interest Rates and Bond Prices
Have an Inverse Relationship
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When rates go up, newly issued bonds come to market with higher yields than existing bonds. The newly issued bonds are more attractive than comparable existing bonds with lower yields. In order to sell their existing bonds, investors will likely reduce their prices to make them equally attractive.
How do interest rates generally affect different sectors of the fixed income market?
Among all bonds, U.S. government bonds and government agency bonds tend to be the most sensitive to interest rate fluctuations because of their high credit quality.
Municipal bonds are also sensitive to interest rate movements because of their generally high credit quality and low default risk.
Corporate bonds react to interest rate changes relative to the credit quality of the issue. Higher-quality corporate bonds typically react more to interest rate changes than corporate bonds of lower credit quality. For example, low-quality or high-yield corporate bonds tend to be more affected by changes in company fundamentals than interest rate fluctuations.
Foreign bonds also tend to react more to credit fundamentals, currency trading and foreign economic conditions, rather than U.S. interest rate movements.
Adjustable-rate mortgages and floating-rate bank loans are generally less sensitive to interest rate changes because their rates reset periodically.
How do interest rates affect my fixed income fund's total return?
Income is the most important part of total return. While fixed income fund prices will fluctuate with interest rate changes, price movement is only part of your fund's total return.
What Is Total Return?
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As a fixed income fund investor, you generally receive monthly income. Historically, income return has been the largest component of total return for bonds. In fact, for the 20-year period ended September 30, 2008, income represented 94% of government bond total returns, 100% of corporate bond total returns and 96% of municipal bond total returns.2
Since bonds generally pay interest whether their prices move up or down, the interest from bonds can help cushion a fixed income fund's overall total return, especially when rates are rising.
How do interest rates affect my fixed income fund's dividends?
As rates rise, dividend amounts may increase over time. When interest rates rise, fixed income fund managers may have the opportunity to invest in new, higher-yielding bonds. As a result, a fund's investment earnings may increase, and thus over time a fund may be able to pay out higher dividends to shareholders.
Funds can only pay out what they earn. When interest rates decline, fixed income fund managers have to reinvest the proceeds from bonds that have matured or have been called at lower rates. Because funds are investing in bonds with lower yields, their investment earnings decline, and the dividends paid out to shareholders also decline.
Why fixed income? Income and diversification
The key reasons to own fixed income funds don't change with interest rates or market conditions. In addition to providing monthly income, fixed income funds are also an important component of a diversified portfolio. Because the bond and stock markets often behave very differently, fixed income funds can play a key role in helping to reduce the impact of stock market volatility on an investor's overall portfolio. Also, generally speaking, bonds historically have been less volatile than stocks.3
A word about risk
Bond prices are affected by interest rate changes. Bond prices, and thus a bond fund's share price, generally move in the opposite direction of interest rates. As the prices of bonds in a fund adjust to a rise in interest rates, the fund's share price may decline. This and other risks are detailed in a fund prospectus.
A financial advisor can add perspective
If you have questions about fixed income investing, we urge you to contact your financial advisor, who is best suited to help you make investment decisions based on your individual investment objectives and risk tolerance.
For more information on Franklin Templeton fixed income funds, contact your financial advisor or download a free prospectus. For more information on Franklin tax-free income funds, contact your financial advisor, or download a free prospectus. Investors should carefully consider a fund's investment goals, risks, charges and expenses before investing. A prospectus contains this and other information. Please carefully read the prospectus before you invest or send money.
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