The Federal Reserve’s Unprecedented Moves: What it means to bond owners
In response to the COVID-19 pandemic, almost every state in America has been under some sort of stay-at-home order. This unprecedented time has also led many businesses, large and small, to downsize or close shop entirely. In response to the financial havoc that COVID-19 has wrought, the Federal Reserve has taken some dramatic steps to buttress the American economy.
A Reserve reminder. The Federal Reserve is mandated by Congress to promote employment and stable prices. The Fed also is responsible for the stability of the financial system, including the safety and soundness of the nation’s banking structure. To pursue these goals, the Fed uses its full arsenal to provide support for the flow of credit to families and businesses.
The Fed’s main tool to affect economic activity is its interest rate policy. Lower rates make it easier for individuals, businesses, and governments to borrow money to buy things they need and want. Credit is the lifeblood of the American economy and everyone needs access to affordable loans. In March, the Fed cut rates from a target range of 1.5% - 1.75% to a target range of zero to 0.25% and it plans to keep them low for the foreseeable future. This lowers the cost of borrowing, but it also reduces the amount of interest income savers receive. This is most easily seen in bank savings account and CD rates.
What does this mean for bond owners? Like a homeowner refinancing a mortgage at a lower rate, a bond issuer wants to refinance its debt when interest rates drop. To do this, it calls its outstanding bonds so it can issue new bonds at a lower interest rate—thus saving the issuer money. The bond’s principal is repaid early and the bond investor is left unable to find a similar bond with as attractive a yield. This is known as “reinvestment risk” and is one of the many risks that need to be balanced when buying bonds and building a diversified investment portfolio.
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