I’m having trouble figuring out what the following statements from a finance website mean:
“By buying bonds, the value increases and the interest rate on them declines. The Fed are trying to reduce interest rates on long term bonds to encourage banks to spend less money on buying Treasury bonds and lend more to private sector. (If treasury yields fell to 0%, it is less attractive to buy bonds.)”
How does the Fed’s buying spree drive up the value of bonds? Why does the interest rate decline?
The value increases because of supply and demand.
The interest rate decreases because the original bond terms haven’t changed: the government still has to pay the exact same amount of interest. When a bond is sold, it pays fixed amount per year, no matter what the current owner paid for it. So if you sell it to Bank A for $1000 and you’ve committed to pay $100 per year, it is paying around 10% interest to the bank.
Then let’s say the Fed performs its magic and the value of the bond increases to $2000. So the bank sells it to Joe Bondbuyer for $2000. But the commitment behind the original bond doesn’t change: it’s still only on the hook for $100 a year. So Joe Bondbuyer is only getting around 5% from owning the bond.
So, when value of a bond increases, its interest rate decreases.
So the interest rate of the bond isn’t determined in advance?
It is determined in advance, for the original purchaser. However, people can buy and sell bonds between the time of initial purchase and the time of final redemption. The interest rate for the people buying then is based on the difference between what they pay and the value when the bond reaches maturity: it really has nothing to do with the initial interest rate.
A very simple example:
Consider a bond with a fixed yearly payment of 5$ and a price of $100.
$5/$100 = 5% yield.
Suppose there is demand for this bond and the price rises to $120.
$5/$120 = 4.2% yield.
Now suppose that there is concern over the creditworthiness of the bond issuer and the bond trades lower.
$5/$80 = 6.25% yield.
The idea is that by driving the price up and yield down, investors will look to put their money some place they might earn a better return.
Why would the price of a bond rise or fall? Aren’t the payments pre-determined?
Yes. The payments are pre-determined. The price is not. The payment does not vary. The price can vary. When the price varies and the payment is fixed, the interest rate can vary.
Why would the price vary if the payout over the life of the bond remains the same?
I think you’re confusing specific bonds vs. bonds in general. For a specific bond its payments are indeed pre-determined at the time of purchase. But its price can fluctuate as the prevailing interest rates change, such as when the Fed makes its interest rate decisions.
Ah, that helps a bit. How do the Fed’s interest rate decisions affect bonds? Are there also two prices (i.e., issue price and resale price)?
I’ll assume that we’re talking about traditional fixed coupon or zero-coupon rate corporate bonds.
First let’s talk about how bonds are priced at issuance. The interest rate that a corporation pays to its bondholders can be bifurcated into 2 parts: 1) the risk-free rate of return* (or what the US government would pay in interest for a bond with the same tenor) and 2) the credit spread (which is based on the perceived riskiness of the bond).
*Over the long run, the risk-free rate won’t be lower than the implied rate of inflation
Thus if the risk-free rate for a 10-year T-bond is 4%, then a newly-issued Corporation X 10-year bond (Bond A) will pay an interest rate of 4% plus the credit spread. Let’s say the credit spread is 2%. Now the total interest rate paid will be 6% ~typically in the form of semi-annual coupons.
Now let’s say that next week, the 10-year T-bond falls to 3%. Thus, if Corporation X issued the same bond next week, it would only have to pay 5% interest (3% risk-free rate plus 2% credit spread). This is Bond B.
You’re an investor looking to buy a Corporation X bond. Which one would you prefer, Bond A or Bond B? Of course, you’d want Bond A, since it pays you more interest for the same amount of risk. In fact, you would be competing with other investors to buy Bond A until its price reached a point where its yield would equal that of Bond B. This means that Bond A is trading at a “premium”.
It’s a well-known fact in Finance 1A that bond prices and interest rates have an inverse relationship. Think of it this way … If interest rates go up, to attract investors a bond (with its set interest rate) will have to drop its price. And the reverse occurs if interest rates drop. That’s as simple as I can explain it.
But wouldn’t the resale prices of the bonds become equal over time?
Yes, the bond price approaches its face value as it approaches maturity.
I think I quoted the wrong post–my apologies. I meant that the resale prices of Bond A and Bond B would move closer to each other, correct?
It might be easier to think about a company’s bonds.
Another simplified example:
Think of a company like Citigroup, or any troubled bank, during the worst of the financial crisis. As an example, say they issued a bond in 2005 paid that 5$ per year and cost $100. Times were good then. As the crisis worsened there were serious doubts about whether Citigroup would survive - aka continue to make bond payments. As a consequence, the price of Citi’s bonds fell.
Imagine you own Citi bonds at a price of $100 yielding 5%. You are panicking because you are afraid they will default and go to zero. You look at the secondary trading market and find that there are other people bidding for your bonds at $50 (which would be a 10% yield). They aren’t willing to accept only 5% return in exchange for accepting what they view to be a large financial risk - they want 10%. You would be taking a 50% loss on your principal investment if you were to sell.
Multiply that type of decision making process many times over and you will have a liquid bond market with moving prices.
(note: As is being discussed, time to maturity and couple other things influence prices. I’m just trying to illustrate how perceived creditworthiness of an issuer can influence how bond prices can move.)
Does value = yield? If the Fed buys up bonds, does that mean that investors will have to pay higher prices for the bonds that remain on the market? Does that mean that yields go UP or DOWN? And how does the interest rate relate to all of this? Is it the interest rate of that bond, or the interest rate of all bonds?
Think about it this way and let’s exaggerate interest rates to illustrate. Suppose in 2011, the interest rate that you can get in any savings account is 5% and bonds sell for 6%. Now, in 2012 interest rates jump tremendously. Let’s say that next year you can get 11% in any savings account. The bond you bought last year which only pays 6% is not very attractive to a buyer. You will have to sell the bond at a discount off of the face value in order to encourage someone to buy it.
Likewise, interest rates in a savings account are 1% in 2012. You have a very attractive bond that many people will want to buy. You can get a premium for the bond and charge above and beyond the face value.
The interest rate on the bond is fixed, so as the other interest rates fluctuate, the value of the bonds moves inversely to these interest rates.