For the purposes of studying how economic indicators impact bond rates we need to understand how bonds are priced and the relationship between prices and interest rates, since that is what is relevant for our agenda. We need to understand this relationship as it is an essential building block to further understanding how each macroeconomic indicator influences the prices of bonds.
We start with the basics of bond cash flow and discount rates and look at an example of how bond prices are inversely related to interest rates. Next, we look at the linkages between bond prices, economic growth, inflation and interest rates.
Bond Instruments: Understanding cash flows
The cash flows of a fixed income instrument or bond instrument is similar to that of a loan product.
Figure: Comparison of Cash Flows Between a Loan Product and a Bond Instrument
In a loan product there is an initial amount of money called the principal that the lender pays to the borrower. In a bond instrument this principal payment flows from the buyer of the instrument to the seller. The intermediate payments in a loan product are interest payments that the borrower needs to pay to compensate the lender for the principal. In a bond instrument these are called coupon payments and flow from the seller to the buyer on a periodic basis such as monthly, quarterly, semi-annually or annually. At the end of the loan period, or term, the principal that was borrowed is repaid to the lender along with the final interest payment. Itâ€™s the same case with the bond, as the principal and coupon is paid to the bond buyer on maturity.
Bond Instruments: Bond Prices and InterestÂ Rates
As mentioned earlier, the difference between bonds and loans is that bonds can be publicly traded. An instrument that is traded publicly therefore needs to be priced in order for it to be bought or sold. Pricing a bond is done by using the present value of future cash flows. In order to get the present value, that is the value of the cash flows today, we need to discount the cash flows by the discount rate. By discounting we basically mean dividing cash flows by the discount rate. The discount rate is the return one could obtain if they invested in a similar instrument; and by a similar instrument we mean an instrument with a similar risk profile.Â
Letâ€™s take the example of a bond instrument. This is a five- year government security with a 10% coupon. The first column consists of the bond’s term of 1,2,3,4,5 years. The coupon interest is in the next column. The purchaser of the bond receives the payment of the principal of 100 dollars at the end of the term. This is called redeeming the bond. The total future cash flow is therefore a series of coupon payments of $10 in each period plus a principal repayment at the end of a $100. Each cash flow is discounted for that term based on the discount rate of 11.35%. When you add all the cash flows you get the price of the bond which is 95.05. This discount rate of 11.35% is also called the bond’s yield.
If there existed an alternative instrument that, for example, yielded 12% with the same risk profile, people would prefer to invest in the 12% instrument since it provides a higher yield than the 11.35% Government security. This would cause investors to sell the 11.35% yielding bond, thereby lowering the price, until the yield of the bond moves higher to 12%. We see that in order for the yield to become 12% the bond price needs to fall to 92.79. We can see here that as discount rates increase bond prices fall. If the discount rate falls down to 10%, which is the same as the coupon rate, the bond price now equals the face value.
If the discount rate falls below the 10% coupon rate to 6% the bond price will move higher. Understanding this inverse relationship between bond prices and interest rates is key to understanding the effect of macroeconomic factors on bond prices. If economic factors cause market interest rates to move higher, bond prices drop, which is bad for the bond markets. Alternatively, macroeconomic indicators that cause market interest rates to move lower push bond prices upwards and cause a bond market rally.
Next we need to understand the influence of economic factors on bond rates