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THE BOND MARKET

THE BOND MARKET. Frederick University 2014. The Bond Market. Bond supply Bond demand Bond market equilibrium. Bond supply. bond issuers/ borrowers look at Q s as a function of price, yield. Bond supply. lower bond prices higher bond yields more expensive to borrow lower Qs of bonds

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THE BOND MARKET

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  1. THE BOND MARKET Frederick University 2014

  2. The Bond Market • Bond supply • Bond demand • Bond market equilibrium

  3. Bond supply • bond issuers/ borrowers • look at Qs as a function of price, yield

  4. Bond supply • lower bond prices • higher bond yields • more expensive to borrow • lower Qs of bonds • so bond supply slopes up with price

  5. S Bond price Q of bonds

  6. Bond Demand • bond buyers/ lenders/ savers • look at Qd as a function of bond price/yield

  7. Bond yield Qd of bonds bond demand slopes down with respect to price price of bond Qd of bonds

  8. D Bond price Quantity of bonds

  9. Changes in bond price/yield • Move along the bond demand curve • What shifts bond demand?

  10. Wealth • Higher wealth increases asset demand • Bond demand increases • Bond demand shifts right

  11. P D D Qd

  12. a change in expected inflation • rising inflation decreases real return inflation expected to demand for bonds (shift left)

  13. a change in exp. interest rates • rising interest rates decrease value of existing bonds demand for bonds (shift left) int. rates expected to

  14. a change in the risk of bonds relative to other assets demand for bonds (shift left) relative risk of bonds

  15. a change in liquidity of bonds relative to other assets relative liquidity of bonds demand for bonds (shift rt.)

  16. Bond supply • Changes in bond price/yield • Move along the bond supply curve • What shifts bond supply?

  17. Shifts in bond supply • Change in government borrowing • Increase in government borrowing • Increase in bond supply • Bond supply shifts right

  18. S S’ P Qs

  19. a change in business conditions • affects incentives to expand production supply of bonds (shift rt.) exp. profits • exp. economic expansion shifts bond supply rt.

  20. a change in expected inflation • rising inflation decreases real cost of borrowing supply of bonds (shift rt.) exp. inflation

  21. Bond market equilibrium • changes when bond demand shifts, and/or bond supply shifts • shifts cause bond prices AND interest rates to change

  22. Example 1: the Fisher effect • expected inflation 3%

  23. exp. inflation rises to 4% • bond demand -- real return declines -- Bd decreases • bond supply -- real cost of borrowing declines -- Bs increases

  24. bond price falls • interest rate rises

  25. Fisher effect • expected inflation rises, nominal interest rates rise

  26. Example 2: economic slowdown

  27. bond demand • decline in income, wealth • Bd decreases • P falls, i rises • bond supply • decline in exp. profits • Bs decreases • P rises, i falls

  28. shift Bs > shift in Bd • interest rate falls

  29. Why shift Bs > shift Bd? • changes in wealth are small • response to change in exp. profits is large • large cyclical swings in investment

  30. Why are bonds risky? • 3 sources of risk • Default • Inflation • Interest rate

  31. Default risk • Risk that the issuer fails to make promised payments on time • Zero for government debt • Other issuers: corporate, municipal, foreign have some default risk • Greater default risk means a greater yield

  32. Inflation risk • Most bonds promise fixed interest payments • Inflation erodes the real value of these payments • Future inflation is unknown • Larger for longer term bonds

  33. Interest rate risk • Changing interest rates change the value (price) of a bond in the opposite direction. • All bonds have interest rate risk • But it is larger for the long term bonds

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