2012-03-19 12:03:25
April 13 2009 | Filed Under Bonds , Economics
Ownership of a bond is the ownership of a stream of future cash payments. Those
cash payments are usually made in the form of periodic interest payments and
the return of principal when the bond matures. In the absence of credit risk
(the risk of default), the value of that stream of future cash payments is
simply a function of your required return based on your inflation expectations.
If that sounds a little confusing and technical, don't worry, in this article
we'll break down bond pricing, define the term "bond yield" and demonstrate how
inflation expectations and interest rates determine the value of a bond.
Measures of Risk
There are two primary risks that must be assessed when investing in bonds:
interest rate risk and credit risk. Though our focus is on how interest rates
affect bond pricing, otherwise known as interest rate risk, it's also important
that a bond investor be aware of credit risk. (Read Managing Interest Rate Risk
to learn more about the risk that comes with changing rates.)
Interest rate risk is the risk of changes in a bond's price due to changes in
prevailing interest rates. Changes in short-term versus long-term interest
rates can affect various bonds in different ways, which we'll soon discuss.
Credit risk, meanwhile, is the risk that the issuer of a bond will not make
scheduled interest and/or principal payments. The probability of a negative
credit event or default affects a bond's price the higher the risk of a
negative credit event occurring, the higher the interest rate investors will
demand for assuming that risk.
Bonds issued by the United States Treasury to fund the operation of the U.S.
government are known as U.S. Treasury bonds. Depending on the time until
maturity, they are called bills, notes or bonds. Investors consider U.S.
Treasury bonds to be free of default risk. In other words, investors believe
there is no chance that the U.S government will default on interest and
principal payments on the bonds it issues. For the remainder of this article,
we will use U.S. Treasury bonds in our examples, thereby eliminating credit
risk from the discussion.
Calculation of a Bond's Yield and Price
To understand how interest rates affect a bond's price, you must understand the
concept of yield. While there are several different types of yield
calculations, for the purposes of this article we will use the
yield-to-maturity (YTM) calculation. A bond's YTM is simply the discount rate
that can be used to make the present value of all of a bond's cash flows equal
to its price. In other words, a bond's price is the sum of the present value of
each cash flow where the present value of each cash flow is calculated using
the same discount factor. This discount factor is the yield. When a bond's
yield rises, by definition, its price falls, and when a bond's yield falls, by
definition, its price increases. (To learn more on this concept, be sure to
read Get Acquainted With Bond Price/Yield Duo.)
A Bond's Relative Yield
The maturity or term of a bond largely affects its yield. To understand this
statement, you must understand what is known as the yield curve. The yield
curve represents the YTM of a class of bonds (in this case U.S. Treasury
bonds). In most interest rate environments, the longer the term to maturity,
the higher the yield will be. This should make intuitive sense because the
longer the period of time before a cash flow is received, the more chance there
is that the required discount rate (or yield) will move higher. (Be sure to
read Bond Yield Curve Holds Predictive Powers to learn more about this measure
of economic activity, inflation levels and interest rate expectations.)
Inflation Expectations Determine Investors Yield Requirements
Inflation is a bond's worst enemy. Inflation erodes the purchasing power of a
bond's future cash flows. Put simply, the higher the current rate of inflation
and the higher the (expected) future rates of inflation, the higher the yields
will rise across the yield curve, as investors will demand this higher yield to
compensate for inflation risk.
Short-Term, Long-Term Interest Rates and Inflation Expectations
Inflation - and expectations of future inflation - are a function of the
dynamics between short-term and long-term interest rates. Worldwide, short-term
interest rates are administered by nations' central banks. In the United
States, the Federal Reserve Board's Open Market Committee (FOMC) sets the
federal funds rate. Historically, other dollar-denominated short-term interest
such as LIBOR are highly correlated with the fed funds rate. The FOMC
administers the fed funds rate to fulfill its dual mandate of promoting
economic growth while maintaining price stability. This is not an easy task for
the FOMC; there is always much debate about the appropriate fed funds level,
and the market forms its own opinions on how well the FOMC is doing.
Central banks do not control long-term interest rates. Market forces (supply
and demand) determine equilibrium pricing for long-term bonds, which set
long-term interest rates. If the bond market believes that the FOMC has set the
fed funds rate too low, expectations of future inflation increase, which means
long-term interest rates increase relative to short-term interest rates - the
yield curve steepens. If the market believes that the FOMC has set the fed
funds rate too high, the opposite happens, and long-term interest rates
decrease relative to short-term interest rates - the yield curve flattens.
(Whenever you hear the latest inflation update on the news, chances are that
interest rates are mentioned in the same breath. Read the Inflation And
Interest Rates section of our Inflation Tutorial to learn more about their
relationship.)
The Timing of a Bond's Cash Flows and Interest Rates
The timing of a bond's cash flows is important. This includes the bond's term
to maturity. If market participants believe that there is higher inflation on
the horizon, interest rates and bond yields will rise (and prices will
decrease) to compensate for the loss of the purchasing power of future cash
flows. Those bonds with the longest cash flows will see their yields rise and
prices fall the most. This should be intuitive if you think about a present
value calculation - when you change the discount rate used on a stream of
future cash flows, the longer until a cash flow is received, the more its
present value is affected. The bond market has a measure of price change
relative to interest rate changes; this important bond metric is known as
duration. (To learn more about duration, be sure to check out the Duration
section of our Advanced Bond Concepts Tutorial.)
Summing It Up
Interest rates, bond yields (prices) and inflation expectations have a
correlation to each other. Movements in short-term interest rates, as dictated
by a nation's central bank, will affect different bonds with different terms to
maturity differently depending on the market's expectations of future levels of
inflation.
For example, a change in short-term interest rates that does not affect
long-term interest rates will have little effect on a long-term bond's price
and yield. However, a change (or no change when the market perceives that one
is needed) in short-term interest rates that affects long-term interest rates
can greatly affect a long-term bond's price and yield. Put simply, changes in
short-term interest rates have more of an effect on short-term bonds than
long-term bonds, and changes in long-term interest rates have an affect on
long-term bonds, but not short-term bonds.
The key to understanding how a change in interest rates will affect a certain
bond's price and yield is to recognize where on the yield curve that bond lies
(the short end or the long end), and to understand the dynamics between short-
and long-term interest rates. With this knowledge, you can use different
measures of duration and convexity to become a seasoned bond market investor.
(For further reading on bonds and the bond market, read our Bond Basics
Tutorial and our Advanced Bond Basics Tutorial.)
by Barry Nielsen