Bond interest rates

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Rex23
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Joined: Mon Apr 01, 2019 12:08 am

Bond interest rates

Post by Rex23 » Mon Jun 10, 2019 11:43 pm

Hi,

I was hoping somebody would be able to explain why interest rates for bonds go up and down. Many articles explain the relationship between the price of bonds and interest rated, however I cannot find what information on whatmakes the interest rates move up or down.

I notice that there seems to be an inverse relationship between the stock price and bond price, and was wondering if bond interest rates are simply influenced by the supply/demand for bonds. For example if stocks are falling, people move money to bonds thereby increasing the demand for bonds and lowering interest rates.

Any links, info, theory would be helpful.

thanks

Valuethinker
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Re: Bond interest rates

Post by Valuethinker » Tue Jun 11, 2019 3:03 am

Bond prices move the opposite direction of interest rates. Because most coupons are fixed and most bonds redeem at par (i.e. $100 per $100 face value of bonds) the value of that fixed promise fluctuates in response to the opportunity to invest in other instruments that might pay a higher yield at that moment.

In fact the "Yield Curve" of interest rates vs time to maturity (x axis) is derived from US Treasury bond prices & yields-to-maturity, normally.

The Fed sets the underlying short term interest rate - the rate at which banks can borrow from and deposit money at the Fed. The markets then move the prices of longer term securities (and thus the yields) to match expectations of where interest rates are going & supply & demand for bonds.

If the Fed does not like the shape of the yield curve, it intervenes directly in the market via Open Market Operations.

If it wants interest rates to rise, it sells bonds, thus driving the price down and raising yields.

If it wants interest rates to fall, it buys bonds, driving prices up and thus lowering yields.

Normally the Fed only works for relatively short maturities (up to one year, say). However since the Global Financial Crisis, it has practiced "Quantitative Easing" - buying and holding bonds all along the yield curve (out to 30 years, even), and not just US Treasury bonds, but also US Agency bonds (FNMA, FMAC, GNMA etc) and (not sure about this) possibly some corporate bonds. In the latter case there is actually the possibility of the Fed making a loss due to bond default (it normally only buys bonds with a US government guarantee) so it is unknown territory.

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Wiggums
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Re: Bond interest rates

Post by Wiggums » Tue Jun 11, 2019 5:15 am

Valuethinker wrote:
Tue Jun 11, 2019 3:03 am
Bond prices move the opposite direction of interest rates. Because most coupons are fixed and most bonds redeem at par (i.e. $100 per $100 face value of bonds) the value of that fixed promise fluctuates in response to the opportunity to invest in other instruments that might pay a higher yield at that moment.

In fact the "Yield Curve" of interest rates vs time to maturity (x axis) is derived from US Treasury bond prices & yields-to-maturity, normally.

The Fed sets the underlying short term interest rate - the rate at which banks can borrow from and deposit money at the Fed. The markets then move the prices of longer term securities (and thus the yields) to match expectations of where interest rates are going & supply & demand for bonds.

If the Fed does not like the shape of the yield curve, it intervenes directly in the market via Open Market Operations.

If it wants interest rates to rise, it sells bonds, thus driving the price down and raising yields.

If it wants interest rates to fall, it buys bonds, driving prices up and thus lowering yields.

Normally the Fed only works for relatively short maturities (up to one year, say). However since the Global Financial Crisis, it has practiced "Quantitative Easing" - buying and holding bonds all along the yield curve (out to 30 years, even), and not just US Treasury bonds, but also US Agency bonds (FNMA, FMAC, GNMA etc) and (not sure about this) possibly some corporate bonds. In the latter case there is actually the possibility of the Fed making a loss due to bond default (it normally only buys bonds with a US government guarantee) so it is unknown territory.
+1

Well stated

livesoft
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Re: Bond interest rates

Post by livesoft » Tue Jun 11, 2019 5:25 am

I think of it this way:

Interest and especially bond interest is simply the cost of Money. Or the price of money if you want to think of it that way. All the things you have and use cost money: Food, Clothing, Shelter, Stuff. Many businesses don't have enough money to pay for the things they need just like many people don't have enough money to pay for the things they need. So businesses need to buy money.

But how do you buy money without having any money to begin with? That's where bonds and bond interest come in. So yes, it is supply and demand along with an extra bit about whether the buyer is good enough with paying back the money purchased in full, that is, creditworthiness.
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Call_Me_Op
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Re: Bond interest rates

Post by Call_Me_Op » Tue Jun 11, 2019 5:33 am

Lots of people are confused by this. There are new bonds being issued all the time. They are issued at specific interest rates that depend upon many factors, but mainly the state of the economy and the financial health of the issuing entity. The interest rates on new bonds affect the value of existing bonds (for obvious reasons).
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Swimmer
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Re: Bond interest rates

Post by Swimmer » Tue Jun 11, 2019 7:12 am

Valuethinker wrote:
Tue Jun 11, 2019 3:03 am
Bond prices move the opposite direction of interest rates. Because most coupons are fixed and most bonds redeem at par (i.e. $100 per $100 face value of bonds) the value of that fixed promise fluctuates in response to the opportunity to invest in other instruments that might pay a higher yield at that moment.

In fact the "Yield Curve" of interest rates vs time to maturity (x axis) is derived from US Treasury bond prices & yields-to-maturity, normally.

The Fed sets the underlying short term interest rate - the rate at which banks can borrow from and deposit money at the Fed. The markets then move the prices of longer term securities (and thus the yields) to match expectations of where interest rates are going & supply & demand for bonds.

If the Fed does not like the shape of the yield curve, it intervenes directly in the market via Open Market Operations.

If it wants interest rates to rise, it sells bonds, thus driving the price down and raising yields.

If it wants interest rates to fall, it buys bonds, driving prices up and thus lowering yields.

Normally the Fed only works for relatively short maturities (up to one year, say). However since the Global Financial Crisis, it has practiced "Quantitative Easing" - buying and holding bonds all along the yield curve (out to 30 years, even), and not just US Treasury bonds, but also US Agency bonds (FNMA, FMAC, GNMA etc) and (not sure about this) possibly some corporate bonds. In the latter case there is actually the possibility of the Fed making a loss due to bond default (it normally only buys bonds with a US government guarantee) so it is unknown territory.

Excellent post! I’ve been in bonds for a long time. One thing I noticed this morning, though, is that my bonds went down overnight. If interest rates are falling, why did my bonds fall? I know I’m oversimplifying, but I don’t think I’ve seen this before—or at least I didn’t notice it.

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Dialectical Investor
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Re: Bond interest rates

Post by Dialectical Investor » Tue Jun 11, 2019 8:24 am

Swimmer wrote:
Tue Jun 11, 2019 7:12 am

Excellent post! I’ve been in bonds for a long time. One thing I noticed this morning, though, is that my bonds went down overnight. If interest rates are falling, why did my bonds fall? I know I’m oversimplifying, but I don’t think I’ve seen this before—or at least I didn’t notice it.
If the price of your bonds decreased, then the relevant interest rates did not decrease. So the question would be, why are some interest rates falling and not others? That would depend on what rates you are referring to, and even then, the answer may be very general and unsatisfactory.

Topic Author
Rex23
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Re: Bond interest rates

Post by Rex23 » Tue Jun 11, 2019 9:02 am

Thank you very much for the helpful replies, I never actually thought of how the Fed executes on raising/lowering the interest rates when they announce it, this was super helpful.

Am I correct in assuming that the Fed can only control one part of the bond market (e.g government bonds)? Corporate and municipal bonds could be affected by multiple factors?

If the Fed sells/buys bonds and affects the interest rates of government bonds, newly issued corporate/muni bonds will need to better that interest rate in order to be attractive and so are influenced by it?

I am assuming that the Fed has big a enough piece of the bond cake that they will always be in control.

So in my head, the total bond interest rate is affected by:
1. The Fed
2. Supply/Demand for bonds
3. Other factors like the quality (e.g bonds being downgraded/upgraded)



thanks again

Topic Author
Rex23
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Joined: Mon Apr 01, 2019 12:08 am

Re: Bond interest rates

Post by Rex23 » Tue Jun 11, 2019 9:08 am

And I apologize, this topic should have probably gone to “Investing - Theory, News & General” forum. I am still trying to find my way around here.

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Phineas J. Whoopee
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Re: Bond interest rates

Post by Phineas J. Whoopee » Tue Jun 11, 2019 1:10 pm

Rex23 wrote:
Tue Jun 11, 2019 9:02 am
Thank you very much for the helpful replies, I never actually thought of how the Fed executes on raising/lowering the interest rates when they announce it, this was super helpful.

Am I correct in assuming that the Fed can only control one part of the bond market (e.g government bonds)? Corporate and municipal bonds could be affected by multiple factors?

If the Fed sells/buys bonds and affects the interest rates of government bonds, newly issued corporate/muni bonds will need to better that interest rate in order to be attractive and so are influenced by it?

I am assuming that the Fed has big a enough piece of the bond cake that they will always be in control.

So in my head, the total bond interest rate is affected by:
1. The Fed
2. Supply/Demand for bonds
3. Other factors like the quality (e.g bonds being downgraded/upgraded)



thanks again
To take a high-level view, the Fed targets one thing (it also controls a couple of other things but usually they're not very significant). It sets a target for the Federal Funds Rate, FFR, the annualized rate at which banks borrow from each other (not from the Fed) overnight. That includes over-weekend. It is the shortest of short term yields. Others take note of it, but the Fed isn't setting anything else (with the couple of minor exceptions I alluded to).

The Fed is not in control. It has influence, but that's all. It normally only holds Treasuries, but has influence far beyond them. It has to buy and sell Treasuries on the open market. Congress, which created the Fed, made it illegal for them to buy Treasuries at original auction.

Bonds, despite popular parlance including here on this forum, do not precisely have interest rates. They have two things:

Coupons: the periodic payments the issuer has to send to the bondholders; and

Yield, by convention Yield to Maturity, YTM, if the speaker doesn't specify differently. YTM takes into account the coupons, and also the present market price of the bond. That's very important because as a bond approaches its maturity date its market price must of necessity converge with its face value. Who would pay much more, or accept much less, than $1,000 for a $1,000 face value thirty-year bond that matures tomorrow?

YTM includes the convergence over time. Of course day by day many other things can affect market prices, but less and less so as bonds approach maturity.

Does that make sense?

PJW

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