Bond Prices and Inflation
The rising price levels for goods and services or inflation has a negative effect on the price of bonds. Rising yields translate to falling prices for bonds. Inflation affects bond returns in terms of nominal and real returns ( Francova, 2018). Inflation means raised price levels, hence a lower buying ability of the interest payments accrued from bonds. For instance, if a bond pays a $100 interest after a year, it means $100 will buy less after a year compared to today. When investors get worried that a bond’s yield would not match the expected inflation, bond prices fall as investors demand less of them.
Bond Prices and Interest Rates
When interest rates rise, the value of bonds goes down. Rising inflation usually prompts the Federal Reserve or central banks to raise interest rates to discourage further borrowing. When short term interest rates go up, long term ones go up too. Fixed income investments are affected negatively by this. When interest rates go up, bond prices fall and vice versa (Rose, 2015). When interest rates rise, there are better returns for investors elsewhere, the price of bonds, therefore, goes down to yield at the prevailing rate.
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Interest Rates as Determined by Demand and Supply
Interest rates are a factor of demand and supply. An increase in the demand for credit raises interest rates (Sims, 2017). A decrease in the demand for borrowing decreases interest rates. Conversely, when credit is abundantly available, interest rates decrease and a decrease in the availability of credit raises the interest rates. More customer deposits mean more money for the lenders. Banks use customer deposits to invest and lend to other customers. If banks are able to lend more, then there is more credit to the economy and interest rates therefore decrease. When interest rates increase, consumers borrow less and when they go down, consumer’s appetite for credit increases.
Interest Rates as Determined by Bond Market
Interest rates have an inverse relationship to bonds. When bond rises, interest rates fall, and vice-versa. Bonds mostly pay a fixed interest rate over a specified time, if interest rates decrease, the interest rates of bonds become more appealing, so investors will then offer a higher price of the bond (Sims, 2017). Similarly, if interest rates are higher, investors will not be appealed by the lesser fixed interest rate paid by a bond, and the value of bonds will subsequently fall. Zero-coupon bonds give a good example of how this system works. Zero-coupon bonds get their worth from the difference of the par value paid at maturity and the time of purchase. For example, if a zero-coupon bond is dealing at $95 and has a par-value of $100, then the bond's return rate is approximately 5.26%. an investor’s contentment with this rate is dependent on what else is currently taking place at the bond market.
These different models provide different results when determining interest rates.
Yield to Maturity
Yield to maturity is the full return expected on a bond if it is held until it matures. It is considered a long-term yield but it is expressed as a yearly rate. It is used to estimate if buying a bond will be a worthwhile investment. Once the yield to maturity is determined, the investor can compare it with the needed yield to define if the bond is a good buy. For instance, a five percent yield means that the asset averages five percent return every year. The correlation between yield to maturity and value remains constant. The lower the price paid for a bond, the higher the yield, and the other way round. The reason for being an investor purchasing the bond has to pay extra for the same return.
Yield to maturity can make a substantial difference in the total amount of interest an investor earns, so it is important to know what influences the price/value of a bond and the yield to maturity re-investment interest rate (Sims, 2017). The price of money makes a difference. The interest rate set by central banks or the Federal Reserve in the short term is a determinant. That interest rate determines what banks pay to get money, and all other rates are pegged on this. This rate determines how much interest an investor gets on top of what is invested. If the central bank/Federal reserve rate will be low, then subsequent interest rates will be low. This means that higher-paying bonds will be more desired and vice versa.
Bond Yields
As bond prices rise, bond yields decrease (Rose, 2015). For instance, if an investor buys a bond that matures in 5 years with a ten percent yearly rate and a face value of a thousand dollars. Every year, the bond will pay $100 in interest. If the rates rise above 10%, the price of the bond is going to decrease if the investor makes a decision to sell it. If rates were to fall to less than ten percent, the price of the bond would increase reason being the coupon payment will be more attractive. The more the interest rates fall, the higher the bond's price will increase and vice versa.
Risk
Bond prices and interest rates have an inverse correlation (Rose, 2015). Bond price risk and interest rates’ fluctuations are closely related aspects. The market price of fixed-rate bonds falls in value when the current interest rates go up. Because the payouts of these bonds are fixed, a fall in their market price translates to an increase in its yield. When the market rate goes up, the price of the bonds will decrease, since investors can get a greater interest rate on their money somewhere else.
References
Francova, B. (2018). An analysis of the impact of selected factors on the bond market. Acta
Universitatis Agriculturae et Silviculturae Mendelianae Brunensis, 6: 1451–1458. https://acta.mendelu.cz/media/pdf/actaun_2018066061451.pdf
Rose, A. (2015). Domestic bond markets and inflation. International Research Federal
Reserve Bank of San Francisco . https://www.frbsf.org/economic-research/files/wp2015-05.pdf
Sims, E. (2017). Bonds, bond prices, interest rates, and the risk and term structure of interest
rates. University of Notre Dame . 3-68 https://www3.nd.edu/~esims1/slides_bonds.pdf
