Question

If bondholders expect the Fed to raise the interest rates what action(s) might the bondholders take? You may discuss what other individuals might due in this situation. Explain your rationale. 200 words

Answer 1

Bondholders will shorten the maturity of the portfolio or switch to a short term bond portfolio. It will then 'catch-up' with the increasing rates but still have a reasonable return. This would improve the return; the Fed will raise rates to slow the money supply. In other words, Bondholders will decrease their demand for existing bonds, thus lowering their prices and rising bond yields even before the fed has pursued its goal. Expectation of even higher future interest rates might cause borrowers to take on loans even when the fed wants to restrain borrowing.

Higher rates mean lower bond prices; it's called an inverse relationship. Longer-term bonds lose more principal value than shorter maturities as rates rise. The higher-yielding the bond is, the less the relationship has tended to be.