Bond – Interest Rate and Inflation
October 4, 2012 in Bond
Bonds are issued at a par value (face value) by the issuer and the investor gets the returns on his investment by the coupon value depending on the offered interest rate. The interest rate offered on bond would be more than the key interest rate or benchmark rate and that would be the only reason that a bond would be a more attractive investment than simply keeping your money in a bank. Please note that till now we are talking about the primary market i.e. when new bonds are issued.
Bond and Inflation
Now what happens if the inflation rises. Inflation rises because of demand and supply gaps. The demand is more than supply and the prices go up. Or the money supply in the market increases and people have more money to spend and the prices start going up.
Now when the inflation goes up, the central banks increase the interest rates to control the money supply. With increased interest rates borrowing the money becomes costlier and hence the money supply gets controlled. But when the benchmark interest rates goes up then the difference in what interest rate you are getting on your investment on bonds and the benchmark interest rate goes down. If there is a drastic rise in the inflation rate and hence interest then even the difference may become negative. The end result is that your purchased bond become a less attractive investment. Now who would like to be stuck with a less attractive investment? The result would be that the market price of the bond would go down. Suppose the face value of the bond was USD 1000 but now when the returns on that bond have become less attractive, you can’t sell that on the market price. The opposite of this would also be true i.e. if the benchmark interest goes down because of a drop in inflation then your bonds will become a more attractive investment as what you are getting as returns is now much better than the market interest rates. At such times the market price of the bond will go up.
Bonds in Secondary Market
Now suppose I wish to buy a bond at the from the secondary market at the current market price, how I would analyze if my investment is worth or not? Simply speaking I will have to compare my investment with the total returns on the bond assuming that I hold the bond till the maturity period. Here comes another term into the picture called “Yield to Maturity”. Please check what are bond yield and yield to maturity (YTM) at Bond Yield and Yield to Maturity.