Understanding interest rates, inflation and bonds

Owning bonds is essentially like owning future cash payment flows. These cash payments are usually made in the form of regular interest payments and principal return at the maturity of the bond.

In the absence of credit risk (default risk), the value of future cash payment flows is only a function of the required return based on your inflation expectations. If this sounds a bit confusing and technical, don’t worry, this article will break down bond pricing, define the term “bond yield”, and explain how inflation expectations and interest rates determine the value of bonds.

Key points

  • Bonds face interest rate risk, because rising interest rates will cause prices to fall (and vice versa).
  • Interest rates respond to inflation: When the price of an economy rises, the central bank usually raises the target interest rate to cool the overheated economy.
  • Inflation will also erode the actual value of the face value of bonds, which is particularly worrying for bonds with longer maturities.
  • Because of these connections, bond prices are very sensitive to changes in inflation and inflation forecasts.

Risk measures

There are two main risks that must be assessed when investing in bonds: interest rate risk and credit risk. Although our focus is on how interest rates affect bond pricing (also known as interest rate risk), bond investors must also be aware of credit risk.

Interest rate risk is the risk of changes in bond prices due to changes in current interest rates. Changes in short-term interest rates and long-term interest rates will affect various bonds in different ways, which we will discuss below. At the same time, credit risk is the risk that a bond issuer cannot pay interest or principal on schedule. The probability of a negative credit event or default will affect the price of a bond-the higher the risk of a negative credit event, the higher the interest rate that investors will require in exchange for taking that risk.

The bonds issued by the U.S. Treasury Department to fund the operations of the U.S. government are called U.S. Treasury bonds. According to the time before maturity, they are called notes, notes or bonds.

Investors believe that U.S. Treasury bonds have no default risk. In other words, investors believe that the US government is unlikely to default on the interest and principal of the bonds issued by it. In the rest of this article, we will use U.S. Treasury bonds in the example to eliminate the credit risk in the discussion.

Understanding interest rate inflation and the bond market

Calculate bond yield and price

To understand how interest rates affect bond prices, you must understand the concept of yield. Although there are several different types of yield calculations, for the purposes of this article, we will use the yield to maturity (YTM) calculation. The YTM of a bond is simply the discount rate that can be used to make the present value of all bond cash flows equal to its price.

In other words, the price of a bond 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 rate of return. When the yield of a bond rises, its price falls by definition, and when the yield of a bond falls, its price rises by definition.

Relative bond yield

The maturity or maturity of a bond greatly affects its yield. To understand this statement, you must understand the so-called 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 maturity period, the higher the yield. This is intuitive, because the longer it takes to receive the cash flow, the more likely it is that the required discount rate (or rate of return) will rise.

Inflation expectations determine investors’ yield requirements

Inflation is the biggest enemy of bonds. Inflation will erode the purchasing power of future cash flows of bonds. In short, the higher the current inflation rate and the higher the (expected) future inflation rate, the higher the yield of the entire yield curve, because investors will require higher yields to compensate for inflation risks.

Please note that Treasury Inflation Protected Securities (TIPS) is a simple and effective way to eliminate one of the most important risks of fixed income investment—inflation risk, while providing a real rate of return guaranteed by the US government. Therefore, it is necessary to fully understand how these tools work, how they work, and how they are included in the investment portfolio.

Short-term and long-term interest rates and inflation expectations

Inflation—and expectations of future inflation—is a dynamic function of short-term and long-term interest rates. Worldwide, short-term interest rates are managed by central banks of various countries. In the United States, the Federal Open Market Committee (FOMC) of the Federal Reserve is responsible for setting the federal funds rate.Historically, other dollar-denominated short-term interest rates, such as LIBOR or LIBID, are highly correlated with the federal funds rate.

The Federal Open Market Committee manages the federal funds rate to fulfill its dual mission of promoting economic growth and maintaining price stability.This is not an easy task for the FOMC. There has been controversy regarding the appropriate level of federal funds, and the market has formed its own views on the performance of the FOMC.

The central bank does not control long-term interest rates. Market forces (supply and demand) determine the equilibrium pricing of long-term bonds, thereby setting long-term interest rates. If the bond market believes that the FOMC has set the federal funds rate too low, future inflation expectations will rise, which means that long-term interest rates will rise relative to short-term interest rates—the yield curve becomes steeper.

If the market believes that the FOMC has set the federal funds rate too high, the opposite will happen, with long-term interest rates falling relative to short-term interest rates—the yield curve flattens.

Time of bond cash flow and interest rate

The timing of bond cash flow is important. This includes the maturity period of the bond. If market participants believe that higher inflation is about to occur, interest rates and bond yields will rise (prices will fall) to make up for the loss of future cash flow purchasing power. The bonds with the longest cash flows have the largest increase in yields and the largest decline in prices.

If you consider present value calculations, this should be intuitive-when you change the discount rate used for future cash flows, the longer the cash flow is received, the more its present value will be affected. The bond market can measure price changes relative to changes in interest rates; this important bond indicator is called duration.

Bottom line

Interest rates, bond yields (prices), and inflation expectations are interrelated. According to the market’s expectations of future inflation levels, changes in short-term interest rates determined by a country’s central bank will have different effects on different bonds with different maturities.

For example, changes in short-term interest rates that do not affect long-term interest rates have little effect on the prices and yields of long-term bonds. However, changes in short-term interest rates that affect long-term interest rates (or unchanged when the market deems it necessary) can greatly affect the prices and yields of long-term bonds. To put it simply, changes in short-term interest rates have greater impact on short-term bonds than long-term bonds. Changes in long-term interest rates have an impact on long-term bonds, but have no effect on short-term bonds.

The key to understanding how interest rate changes will affect the price and yield of a certain bond is to identify the bond’s position on the yield curve (short-term or long-term), and to understand the dynamic term interest rate between the short-term and the long-term.

Armed with this knowledge, you can use different duration and convexity indicators to become an experienced bond market investor.

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