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. In this section 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 bond's issuer 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.
In this section, we'll focus on interest-rate risk. (To learn about credit risk, read Corporate Bonds: An Introduction To Credit Risk.)
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 and 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 rates 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 gets steeper. 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, flattening the yield curve. (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 effect 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.