Fixed-Rate Bonds vs. Adjustable-Rate Bonds
Savers lend money to institutions that seek financing. In exchange, investors are issued bonds that pay interest before returning principal on a set date. Bonds are subject to interest rate risks.
Bonds may be categorized as either fixed-rate or adjustable-rate. Fixed-rate bonds pay the same level of interest throughout maturity. Adjustable-rate bonds pay variable rates according to economic conditions.
Adjustable-rate bonds are often pegged to a particular index. Indexes include federal funds or the London Interbank Offered Rate (LIBOR). Fixed-rate bonds apply interest rates associated with the issuing institution’s financial standing. Investors demand higher interest rates for bonds that carry higher default risks.
Interest rates fluctuate with loan demand. The Federal Reserve Board influences interest rates to manage the economy. The Fed lowers interest rates to encourage growth. Higher interest rates slow down the economy and control inflation.
Fixed-rate bonds are ideal for conservative investors who want to lock in interest rates. Adjustable, or floating-rate bonds, make higher payments when interest rates increase.
Rising interest rates adversely affect fixed-rate bonds. Rising interest rates reduce the value of existing fixed-rate bonds because new bonds pay out more interest. Adjustable-rate bonds make smaller payments as interest rates fall.
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