There has been a lot of talk recently about bond yields rising. This usually happens when central banks decide to raise interest rates. Let’s examine how interest rates affect bond yields. Some concepts that will be used in this analysis:
- Risk-free rate of return: A theoretical rate of return on an investment which carries 0 risk. Does not actually exist because every investment has some risk.
- Bond: A financial instrument that pays investors a regular, fixed amount of money as interest
- Bond yield: The regular payment of the bond interest divided by its price.
Cheat notes: When rates increase, bond yields will rise as bond prices drop. The opposite situation is also true.
So let’s take a step back and look at bonds again. When a company or an institution sells a bond to investors, it is basically taking a loan from investors. As this is a loan, interest must be paid, and the amount is expressed as a percentage. So if $1 million of a bond was sold at an interest rate of 5%, this means that each year, the investor will be paid $50,000, and it is important to reminder that this amount is fixed. That is where bonds get the name “fixed-income products”.
Continuing with the above example, let’s assume the bond is AAA-rated (the highest and most secure rating for a bond) and that the central bank also sells AAA-rated Treasury Bills. These Treasury Bills are currently sold with 4% interest. Investors would most likely prefer to buy the bond as it gives them a better return on their money than buying bonds from the central bank. However, if the central bank raises the interest rates on Treasury Bills over time to 6%, then investing money in central bank Treasury Bills now looks more attractive than buying the same AAA-rated bonds. As per the basics of supply and demand, the bonds now look less attractive, so their price on the secondary market will drop. Since the yield of a bond is calculated as the coupon (which is a fixed dollar amount) divided by the price of the bond, as bond prices drop, their yield increases.
But it’s not just prices of Treasury Bills issued by the central bank that can affect bond yields. Central banks can also set the price at which banks borrow from one another, although the thought process as to how it ultimately affects bond yields works in a similar way. If the central bank sets interest rates higher, then banks would rather lend to one another than buy bonds which have lower interest rates. When this happens, the bonds become less attractive, thus lowering their price and increasing their yield.
So now we realise that bond yields move roughly in tandem with central bank rates. If you expect the central bank to raise rates, this would mean that you anticipate bond yields to go up and bond prices to go down, and vice versa.
Beyond affecting the prices of bonds, rising rates also have an effect on almost everything else. When it becomes more expensive for banks to borrow from one another, their costs of lending to other customers will also increase. When it becomes more expensive for regular people to borrow, they will start to spend less, and this can lead to a slowdown in the economy. In fact, this is what has been happening in the United States for just under two years now. The Federal Reserve has been increasing rates in a bid to slow down the economy so as to control inflation.
Ming Yang completed his degree in Economics at the University of California, Berkeley. Subsequently, he was a private banker at Bank Julius Baer, director at an asset management company and chief marketing officer at a hedge fund. He also organizes summer programs for college-bound students at his alma mater. His three young children serve as his inspiration for teaching the younger generation.