- Rising bond yields are often associated with some pressure in the share market.
- When interest rates fall, investors may prefer investing in bonds rather than stocks, and bond yields fall.
- The bond yields rise in case of economic growth and inflation expectations.
2021 has seen varying episodes of bond yields spike. It, therefore becomes imperative to understand the factors determining bond yields scenario.
Bond yields are determined by dividing the annual coupon rate by the current market price of the bond. Thus, there is an inverse relationship between the price of the bond and interest rates. Simply put, bond yields represent the returns received on a bond.
Due to the inverse relationship between prices and interest rates, monetary policies often end up impacting the bond market. Generally, record low interest rates are implemented by Central Banks to encourage spending and investment in the economy. However, this causes the bond prices to soar, and yields to fall.
At the same time, several other factors impact yields, such as economic growth and inflation expectations. Before we look at the impacts of bond yields, it is essential to understand how bond yields are affected.
Relationship between Bond Yields and Bond Prices
Demand and supply of bonds play a crucial role in determining bond yield and prices both. As bond prices increase, its yield declines, and the converse is also true.
Coupon payments must be the same for two bonds falling in the same category. Thus, if Bond A offers higher yield tomorrow than Bond B today, then Bond A’s prices must adjust to make the coupon payments equal. The bond with the higher yield would be more desired in the market, so its demand would increase, thus, raising its price.
The change in prices of two similar bonds reflects the difference in yields offered by them, to simplify further. This difference must be adjusted by changing the prices. Therefore, bond yields and prices move in the opposite direction.
Dividing the coupon payment by bond price gives the bond yield. Thus, any changes to bond prices have an inverse impact on the yield.
Bond Yields Determinants
Rising yields can be key signals to watch for in the bond market. US treasuries are accepted as a benchmark rate for many of the other bond yields.
Monetary policy decisions are critical determining factors when it comes to bond prices. As interest rates rise, investors might find themselves investing in stocks because bonds would be priced lower. Thus, bond yields rise.
Moreover, positive sentiment in the economy can be harmful to treasury yields, while a slowdown in the economy can cause bond yields to shoot up. Bonds appear overpriced, with low yields, during bouts of optimism in the investor sentiment. A positive sentiment in the economy may be backed by economic growth, which has the capacity to lower yields. High growth allows companies to borrow money and service debt, leading to a reduction in the default rate and consequently, lower yields.
Monetary policy expansion also impacts the risk-free rate of return, which has a subsequent effect on the bond market. However, some bonds may gain from positive changes to the economy. Some of these are emerging market bonds, high-yield bonds, and lower-rated corporate bonds. These bonds may not show any changes with fluctuations in Treasury yields, and thus, we do not use them as a benchmark.
Another essential factor that determines bond yields is inflation expectations. With a potential rise in inflation, the purchasing power of bond’s future cash flows reduces. In other words, market players demand a higher yield to compensate for potential inflation concerns. This has been the major factor driving the bond yields high this year on certain episodes, overpowering the factors such as economic growth prospects and low interest rate.