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Why do bond interest rates plunge?

By David Becker

Bond interest rates are driven by new information such as economic events, monetary policy changes or geopolitical unrest

If you read a finance book that explains the bond market, one of the first pieces of information you will glean is that bond prices move in the opposite direction to interest rates. This means that as the price of a bond rises, so the interest that the bond will pay falls.

The amount that interest rates can change will vary based on the type of bond and on its duration. Interest rates will fluctuate daily, based on market sentiment, new information as well as geopolitical events.

Short-term, overnight interest rates are controlled by the central banks, while all other interest rates are controlled by market participants. The interest rate of a bond is a reflection of what the market believes that interest rates will be at some period in the future.

What is a bond?

A bond is a financial instrument that pays a fixed level of interest, representing a loan from an investor (lender) to a borrower (issuer). The bond sets out the details of the payments. These include the frequency of interest and principal payments and the maturity date (when the loan will be paid back). Bonds are used by national governments, state and local municipalities and companies.

When are bonds used?

If a government or a company needs to raise capital for daily operations or for a new project, they may issue bonds directly to investors. The bond issuer will determine the notional value to be borrowed (the bond principal), when the interest payments will be made and the date on which the loan will be paid back. The initial price of a bond (the par) is generally set at $100 or $1,000.

Bond investors do not have to hold a bond to maturity. If the price of a bond rises and the investor believes that they would like to take the profit, they can. Additionally, it’s common for bond issuers to recall or repurchase a bond if their credit improves and they can borrow at a better interest rate.

What are interest rates?

Interest rates are what is charged by a lender to a borrower for a loan. Interest rates on loans or bonds that are longer than overnight loans are driven by market participants. The interest rates on overnight loans are controlled by central banks.

Sovereign rates generally determine rates that are used at the municipal level and the company level. In the US for example, 10-year US Treasury bonds drive the value of mortgage bonds, which are loans used for housing, state, and local municipal bonds as well as for corporate bonds. As the 10-year US treasury rate rises, mortgage rates will also move higher.

Why do interest rates change?

Central banks use interest rates to stimulate and stifle economic growth and inflation. Each central bank has a mandate. Some are mandated to keep inflation within a specific range, while others are also expected to maximise employment levels.

When economic growth is contracting and inflation is falling, a central bank will lower short-term rates to stimulate growth. Conversely, when economic growth is expanding and inflation is rising, a central bank will raise short- term interest rates to reduce inflation.

While a central bank is in full control of the overnight rates used by banks use to lend to one another, the market controls all other rates. When market participants believe that interest rates will need to move lower to stimulate growth, bond prices will rise. But when market participants believe that rates need to rise in order to cap inflation, bond prices will fall.

When do bond interest rates plunge?

Generally, new information is the catalyst for bond price change. There is a theory that the price of a bond incorporates all the available information – and when new information becomes available, the price will find a new equilibrium. Types of information that drive the price of bonds include economic data, monetary policy information and geopolitical risk.

Unexpected data can cause bond interest rates to plunge or to surge. For example, an unexpected rate cut by a central bank might cause bond interest rates to plunge, while a stronger than expected employment report might push bond interest rates higher.

Certain bonds are considered safe-haven assets. But sovereign bonds in developed countries such as the United States and Japan could see their interest rates plunge in the event of a geopolitical event, such as a terrorist attack.

Key takeaways

  • A bond is similar to a loan that an investor provides to a borrower.
  • Bonds are fixed-income securities that pay a coupon to investors on a regulator basis.
  • The price of a bond will move in the opposite direction of the interest rates the bond is paying.
  • Interest rates change as new information becomes available.
  • Economic data, monetary policy information and geopolitical events are the types of data that can drive bond interest rate change.

FURTHER READING: The pros and cons of different asset classes

FURTHER READING: Portfolio diversification: What are the pros and cons?

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