AFME 325
The Bond Market
1. The Demand for Bonds
Bond demand is based on the behavior of those who buy bonds, or lenders/savers.
Consider a zero coupon bond with a face value of €1000. Suppose the bond has 1 year
until maturity, and the expected holding period is one year. Then the bond's expected return is
equal to its yield to maturity:
Using the formula above, we can calculate the expected return for various prices:
Bond Price i = exp. return
700
42.86%
750
33.33%
800
25%
850
17.65%
900
11.11%
950
5.26%
As the bond price rises, both the yield to maturity and the expected return fall. As the
expected return falls, the quantity demanded of the bond will fall. So the bond demand curve
looks like this:
At higher prices, the quantity demanded of bonds falls. Also, note that higher bond
prices are associated with lower interest rates because bond prices and interest rates are
negatively related.
2. The Supply of Bonds
To determine the level of interest rates, we also need the bond supply curve, which
models the behavior of those who issue bonds, or borrowers. Higher bond prices mean lower
interest rates, which encourage borrowing, holding other factors constant. So the bond supply
curve slopes up with respect to bond prices:
In the bond market above, the equilibrium interest rate is 17.65%.
However, to understand why interest rates are always changing, we need to understand
why equilibrium changes, or why supply and demand curves shift in the bond market.
3. Factors, affecting the demand for bonds
a)
A change in wealth. As wealth increases, people will buy more bonds at each and
every price, and the demand for bonds rises, or shifts right. So when an expanding
economy increases both income and wealth, we expect bond demand to increase too.
b)
A change in expected interest rates/returns. For bonds with more than a year to
maturity, rising interest rates in the future will decrease the value of the bond (and
hence the expected return). At each and every price, fewer bonds will be demanded.
Bond demand will fall, or shift left.
c)
A change in expected inflation. If investors expect the inflation rate to rise, then they
expect the real return on their bond to fall, as future payments are able to buy less.
Higher inflation expectations decrease bond demand.
d)
A change in the relative risk of bonds. At any given price or expected return, if
bonds become riskier than other assets, people will switch to less risky assets. An
increase in the relative risk of bonds with decrease bond demand.
e)
A change in the relative liquidity of bonds. If it becomes harder to resell bonds in
the bond market relative to other assets, people will switch to assets that are easier to
resell. A decrease in the relative liquidity of bonds will decrease bond demand.
4. Factors, affecting the supply of bonds
a)
A change in business conditions. Firms issue bonds to finance the purchase of capital
equipment and the expansion of production. This makes sense only if this expansion is
expected to be profitable. As economic conditions become more favorable, expected
profitability rises and bond supply will increase or shift right. Also tax incentives for
borrowing can also be considered a business condition.
b)
A change in expected inflation. While rising inflation decreases the real return for
those who buy bonds, it decreases the real cost of borrowing for those who issue
bonds: For a given nominal interest rate (and bond price), higher inflation means a
lower real interest rate. Thus, higher expected inflation increases bond supply.
c)
A change in government borrowing. If the government runs budget deficits, the
Ministry of finance must issue additional bonds to finance the shortfall in tax revenue.
At each and every bond price, the quantity supplied increases, so the bond supply
curve shifts right. Conversely, budget surpluses could lead the Ministry of finance to
buy back and retire bonds with the excess revenue and decrease bond supply.
Two things to remember about the bond market:
1. The demand for bonds is the same as the supply of loanable funds. Those who buy
bonds are providing loans to others and are receiving interest.
2. The supply of bonds is the same as the demand for loanable funds. Those who supply
or issue bonds are borrowing money and paying interest.
5. Equilibrium Interest Rates
Any shift in the bond demand and/or bond supply curves implies a new equilibrium
interest rate. Thus, when we observe fluctuating interest rates in the economy, the root cause
is changes in the factors affecting bond supply and bond demand. Let's look a couple of
applications.
a) An increase in expected inflation (The Fisher Effect)
Suppose expected inflation is initially at about 3% with initial bond supply and demand
curves of Bs and Bd. The equilibrium interest rate is 5% :
Now suppose inflation expectations rise to 4%. Bond demand decreases (along with
the expected real return) and bond supply increases (as the real cost of borrowing declines) to
Bs' and Bd'. The new equilibrium interest rate is definitely higher (and the bond price lower):
The total impact on the quantity of bonds here is zero, but in general depends on the
size of the shifts in the bond demand and supply curves.
So the Fisher effect is this: when expected inflation rises, nominal interest rates will
rise. This prediction of our model is validated by time series data on interest rates.
b) An economic slowdown
Let's start again with initial bond supply and demand curves of Bs and Bd. The
equilibrium interest rate is 5% :
We are in the midst of an economic slowdown and concern about a recession. Again
this condition will affect both the bond demand and bond supply curves. With the slowdown
comes a decline in income and wealth the demand for bonds will decrease to Bd''. The
slowdown also has negative implications for profits, so bond supply also declines to Bs'':
In general, where both bond supply and bond demand decrease, the total effect on the
equilibrium interest rate is uncertain. Here the shift in bond supply is larger than the shift in
bond demand, so the interest rate falls. This is consistent with the data on interest rates and the
business cycle: nominal interest rates tend to fall during recessions and rise during
expansions. In other words, interest rates are procyclical.
The table below summarizes that impact of various factors and the bond market and
the equilibrium level of interest rates:
The Effect of Selected Variables on the Bond Market and Equilibrium Interest Rates.
Variable
Wealth
Expected Interest Rates
Expected Inflation
Relative Risk
Relative Liquidity
Business Conditions
Government Borrowing
Change in Variable
Increase
Increase
Increase
Increase
Increase
Increase
Increase
Change in Bd Change in Bs
Increase
Decrease
Decrease
increase
Decrease
Increase
increase
increase
Change in i
decrease
increase
?
increase
decrease
increase
increase
6. The Risks Associated with Holding Bonds
While bonds promise fixed cash flows over times, these financial instruments are not
without risk. The risk varies depending on the issuer and current economic conditions, but all
bonds carry some type of risk. There are three major risks:
a) Default Risk
This is the risk that the bond issuer will fail to make the promised payments in full and
on time. One bond issuer, The government, is considered to have no default risk, so default
risk is not applicable for government bonds. However all other issuers such as private
corporations, state and local governments, and foreign governments might carry some risk of
default. The higher the default risk, the greater the bond yield. Why? Recall that investors are
risk average and will demand a higher yield in order to hold an assets with greater risk.
b) Inflation Risk
Most bonds promise fixed payments (there are some bonds out there where payments
are indexed to inflation). However, with any inflation, those fixed payments will buy fewer
goods and services in the future. Bond yields reflect both a real interest rate and an expected
inflation rate. The risk is that future inflation is uncertain and could be much higher than
expected, which drives down the real return for bondholders. All fixed rate bonds will carry
inflation risk.
c) Interest Rate Risk
Any bond price moves in the opposite direction of interest rates. Therefore a bond's
price or value will fluctuate over the life of the bond as interest rates move up and down. This
fluctuation in value again exposes the bondholder to risk, especially if the bondholder expects
to sell the bond prior to its maturity.
Maturity is a principle bond characteristic that affects price volatility: Prices (and thus
returns) are more volatile for long-term bonds than short-term bonds. In other words, longterm bonds have greater interest-rate risk.
Why is this the case? Intuitively, with a long-term bond, you are "locked in" to a
coupon rate for a longer period of time. So if newer bonds are issued with lower coupon rates,
your long-term bond becomes much more valuable. If new bonds have higher coupon rates,
your long-term bond becomes much less valuable. For a bond with less than 1 year left until
maturity, the change in interest rates will not matter that much. The consequences of changing
interest rates are much more serious for bonds with longer times left until maturity.
ALL BONDS HAVE SOME INTEREST-RATE RISK. So no bond, even government
bonds, are completely risk-free. Three month Government bonds are the closest to a riskfree
bond given their issuer and short time to maturity.