Supply and demand are the basic determinants of prices for bonds and other financial assets. Bond prices rise when demand outpaces supply and fall when there is insufficient demand. A bond's yield, which is the ratio of annual interest payments to market price, rises when its price falls and falls when the price rises. The factors affecting the supply-demand dynamic of bonds include the direction of interest rates, financial health of bond issuers and fiscal policy.
The Federal Reserve sets short-term interest rates as part of its monetary policy mandate to maintain economic growth and price stability. Changes in monetary policy affect other short- and long-term interest rates. Bond prices rise when rates fall because demand rises for older bonds sold at a higher coupon rate, which is a bond's stated interest rate. Conversely, bond prices fall when rates rise because demand falls for older bonds sold at a lower coupon rate. Bond markets usually anticipate changes in interest rates several months in advance of Federal Reserve action. Longer-term bonds are usually more sensitive to interest rates, because there is more time for changes in monetary policy before maturity.
The credit quality of an issuer affects investor demand for its bonds. There is always demand for Treasury bonds because they are considered risk-free investments. Corporate bonds and even bonds issued by some state and local governments are riskier because the issuers could face financial difficulties and default on its obligations. Rating agencies, such as Moody’s and Standard & Poor’s, assign grades to each bond based on their independent assessment of each bond issuer's credit quality. Low-rated bonds have to pay higher interest rates to compensate investors for taking on the additional risk.
Fiscal policy decisions can affect bond prices. Investors may demand higher rates for bonds issued by governments running large budget deficits, as was the case during the Eurozone sovereign-debt crisis of the early 2010s. Excessive public-sector debt may also crowd out private-sector debt, which makes borrowing more expensive for companies. On the other hand, there is usually a high demand for the bonds of countries with balanced budgets, which drives yields lower and prices higher.
Bond prices usually benefit when there is uncertainty and unusual volatility in the stock markets, such as during the 2008 financial crisis. Investors during these times move some of their funds to lower-risk assets, such as Treasury bonds, to prevent their portfolios from significant stock market losses. The higher demand leads to higher bond prices and lower yields. It might even cause an unusual condition called an inverted yield curve, which might not be of concern to investors who are primarily interested in a safe place to park their funds. Once the financial markets stabilize, bond prices may fall as investors move money out of bonds and into stocks.
Video of the Day
- savings bonds image by Stephen VanHorn from Fotolia.com