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Understanding bonds: prices, interest rates and inflation

This animated tutorial delves into how interest rate and inflation expectations drive bond markets.

 

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In the previous module, we hinted at the relationship between a bond’s price and its yield.

We looked at how if a bond’s price goes up, its yield goes down and vice versa. But what causes these changes in prices and yields?

Well, let’s start with interest rates, one of the key contributors to bond price movements.

Suppose an investor buys a bond at its face value of one hundred pounds, with a coupon of five per cent, which exactly reflects the prevailing market interest rate at the time.

Later on down the road, they need to sell the bond. But market interest rates have gone up to six per cent.

No one would buy a bond that only pays five per cent if the market rate is six.

To find a buyer for the bond, they’ll have to lower the price until the effective yield the buyer gets equals the market rate of six per cent. This is why bond prices fall when rates rise.

Remember, that bond will pay out five per cent of one hundred pounds, no matter what price the new investor pays for it. 

But what happens if interest rates in the market drop to four per cent?

The investor wouldn’t sell the bond for anything less than a price that would result in an effective yield of four per cent. In other words, they would want more than the one hundred pound face value of the bond. 

This measure just gives bond investors and traders another rough-and-ready way to compare bonds based purely on changes to interest rates.

They consider many other factors when buying and selling bonds, which will all be covered as we go through the course.

One of the most important things they look at is inflation.

Ultimately, the value of a bond rests on the value of its future cash flows, including recurring coupons and the return of its par value at maturity. But if inflation erodes the real world purchasing power of those cash flows, the bond itself is actually worth less.

So, if inflation goes up, interest rates normally go up too. If interest rates go up, bond prices fall until the yield on the bond takes account of an expected rise in inflation. We’ll come back to this concept later.

For now, remember that if inflation expectations rise across the board, so will bond yields, pushing bond prices down.

But bond markets are made up of people trying to find extra value and profit. So in reality, bond markets are not nearly so mechanical.

When bond investors believe something is going to happen that will affect bond prices, they act on it if they think they can make a profit. For example, if they think inflation will rise in the future, potentially eroding the value of bond cash flows and affecting bond prices, they might seek to sell their bonds before the inflation actually happens.

If enough bond investors in the market feel this way, their selling would bid down bond prices (in turn, bidding up yields).

The opposite is also true.

In other words, just like stock markets, bond markets move according to what investors expect may happen in the future.

Investment risk information:

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.

Other important information:

This video was produced by Vanguard Asset Management, Ltd. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.

If this is to be used on third party websites for an audience of professional investors as the submission suggests I would also include the for professional investors disclaimer at the top.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

© 2018 Vanguard Asset Management, Limited. All rights reserved.