Understanding Interest Rates, Inflation And Bonds

Investing

… from the desk of the CEO
David Fisher

The twin factors that affect a bond’s price are inflation and changing interest rates. A rise in either interest rates or the inflation rate will tend to cause bond prices to drop. Inflation and interest rates behave similarly to bond yields, moving in the opposite direction from bond prices.

Owning a bond is, essentially, like possessing 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.

Measures of Risk

There are two primary risks that must be assessed when investing in bonds: interest rate risk and credit risk.

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.
Credit risk is the risk that the issuer of a bond will not make scheduled interest 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 that there is no chance that the U.S government will default on interest and principal payments on the bonds it issues.

Calculating a Bond’s Yield and Price

To understand how interest rates affect a bond’s price, you must understand the concept of yield. There are several different types of yield calculations. The yield to maturity (YTM) calculation is the most commonly used. A bond’s YTM is 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, wherein 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.

A Bond’s Relative Yield

The maturity or term of a bond largely affects its yield. To understand this you must understand what is known as the yield curve. The yield curve represents the YTM of a class of 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.

Inflation Expectations Determine the Investor’s 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 – as well as 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 U.S., the Federal Reserve Board’s Open Market Committee (FOMC) sets the federal funds rate. Historically, other dollar-denominated short-term interest, such as LIBOR, has been 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 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.

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. 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.

Summary

Interest rates, bond yields (prices) and inflation expectations correlate with one another. 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. 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.

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