The Federal Reserve Board sets monetary policy by adjusting the benchmark short-term interest rate, known as the federal funds rate. The "Fed" raises rates to control inflation and lowers rates to stimulate economic growth. Bond yields fall and prices rise when the Fed lowers interest rates. Prices rise because demand increases for outstanding bonds issued at higher interest rates, at least until the yields on these older bonds match the lower rates on the newer bonds.
According to the Federal Reserve Economic Data charts hosted on the website of the Federal Reserve Bank of St. Louis, short-term and long-term Treasury yields closely track the federal funds rate. Treasury bond yields fall and prices rise when the Fed lowers short-term rates. The spread for longer-term government bonds, such as the 10-year Treasury bond, is about 1 to 2 percentage points higher than short-term bonds, such as the 3-month Treasury bond. In this context, spread is the difference between different bond yields and the federal funds rate.
State and local governments issue municipal bonds to raise funds for services and various projects. Municipal bond yields had generally tracked the federal funds rate until about early 2000. From then until 2012, municipal bond yields have stayed in a narrow range, at times several points higher than the federal funds rate. This is likely because of the risk of local governments defaulting on their debt obligations, especially during the long period of economic uncertainty following the 2008 financial crisis.
Companies issue bonds to raise funds for operations and strategic acquisitions. Corporate bond yields generally track short-term rates. The spread for lower-quality bonds, such as Baa-rated bonds, is higher because of the higher risk of default. The spread is also higher for bonds with longer maturities because of the increased risk of adverse changes in business and economic conditions over a longer period. Corporate bond spreads rose significantly immediately following the 2008 financial crisis because of the high degree of uncertainty surrounding corporate balance sheets and earnings.
Mortgage-backed securities rely on the cash flow from principal and interest payments on the underlying mortgages. As with other bonds, the yields on these securities fall when the Fed lowers interest rates. In addition, homeowners are likely to upgrade to new homes or refinance existing homes when mortgage rates are declining. This increases prepayments on existing mortgages, which could mean that issuers will buy back these securities before maturity and investors would then have to invest the proceeds at lower interest rates.
The Fed can influence bond rates even when the federal funds rate is effectively at zero, as was the case for several years following the 2008 financial crisis. Beginning in late 2008, the Fed started buying long-term Treasuries and other government securities to lower long-term bond rates and borrowing costs and thus spur economic growth.
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- Compound returns chart image by Gramper from Fotolia.com