Interest rates and bonds

Bonds can be highly sensitive to interest rate movements. When a given central bank decides to raise interest rates, it quickly translates into higher yields on the nation´s sovereign bonds.

As there is an inverse relationship between yield and price, higher interest rates lead to lower bond prices. In the opposite direction, lower interest rates push up prices.

Yield changes on government bonds also ultimately impact the yields found in other bond market segments.

Ultra-low rates

The constituents of the global bond market can be thought of as lying along a risk spectrum. At the lowest end of the risk spectrum are the major government bonds, such as US Treasuries and German bunds.

Government bonds such as US Treasuries are so low down on this risk spectrum that economists have historically referred to the yield they generate as representing a “risk free rate”. It´s virtually inconceivable that the US government would ever default on its debt obligations.

10-year US Treasuries, bonds issued by the US government with ten years until their maturity, currently have a yield of just 2.2%.

In July 2007, just prior to the financial crisis, the 10-year US Treasury yield was a little over 5%, a level that had been historically thought of as a reasonable long-term average for the risk-free rate.

Yield hungry investors

The ultra-low official interest rates witnessed in the aftermath of the 2008/2009 financial crisis also pushed down the yields on offer from corporate bonds, as yield hungry investors competed to secure higher yields.

Over recent years, time and again companies have found that their bond issues are well oversubscribed. This has enabled them to issue debt at lower yields than they had even hoped for.

For example, US technology group Qualcomm recently issued debt at a 105 basis points spread above the 10-year US Treasury rate. In other words, it is paying investors a yield just 1.05% higher than that paid by 10-year US Treasuries.

The implication is that corporate bonds are being issued at rates lower than what was previously considered to be the risk-free rate. Of course, corporate bonds are certainly not risk free. There is always a chance that a corporate bond issuer could default on their debt obligations.

Fluctuating yields

Bonds as an asset class are often collectively referred to as “fixed income”. This is because the governments or corporations that issue bonds pay a fixed annual level of interest to bondholders.

However, the yield is calculated by dividing the total annual coupon payments by the price of the bond. As bond prices fluctuate in the market on a daily basis, so do the underlying yields.

Suppose a central bank decides to raise official interest rates. Investors know that the yield on the face value (the value when the bonds are issued) should be higher the next time the nation issues bonds. This naturally pushes down the prices of the existing sovereign bonds already in the market as investors expect higher yields.

Yield curve

Be it for UK gilts, German bunds or US Treasuries, the shape of the government bond yield curve provides a snapshot of market expectations on future interest rates.

With a normal yield curve, yields increase as bond maturities get longer. Theoretically, investors require a higher yield when there is longer to wait until a bond´s maturity.

A normal yield curve can also become steeper when there is increased demand for the shorter-dated bonds.

For example, investors may switch into shorter-dated issues because they think economic activity and inflation will pick up. In this way, they hope to minimise the adverse price impact on their bond portfolios that comes with higher interest rates as central banks tighten their monetary policy.

Normal yield curve.

Changing expectations

It follows that when inflation expectations rise, bond prices tend to fall. This is because central banks generally raise official interest rates when faced with higher inflation.

For instance, the European Central Bank´s primary objective is price stability: over the medium term, it aims to keep inflation below but close to 2%.

While inverse, the relationship between interest rates and bond prices is so significant that just changing expectations on official rates can be enough to move bond prices in either direction.

Strong correlation?

While the relationship between interest rates and prices is strongest for government bonds, high quality corporate bonds, commonly referred to as investment grade, also tend to have a strong correlation with prevailing interest rates.

Smaller companies that issue debt, and/or those deemed to be at higher risk of default, are found in what is known as the high-yield segment of the bond market. These bonds are also referred to as junk or sub-investment grade.

Bonds in this segment may often appear to be much less sensitive to interest rates; specific factors to individual high-yield issuers can dominate.

Higher risk, higher yield

If a company already has an elevated level of existing debt then it may be viewed as being at higher risk of default. Accordingly, such a company may have to offer investors more attractive yields to compensate for the increased level of risk.

There are a wide range of yields offered on the debt of high-yield issuers. Insurance business KIRS recently issued five-year sterling denominated bonds at around 8.4%. A week earlier, leisure firm Center Parcs was able to issue a five-year sterling bond at just 4.25%.

Although also classified as a high-yield issuer, Center Parcs is among those that have benefited significantly from the ultra-low interest rate environment. When it issued debt in early 2012, it paid investors a yield of 11.6%. During the past five years, the interest rate bill on the new debt it issues to investors has therefore fallen by over 60%!

An era of lower yields

Overall, lower yields on government bonds have pushed down yields in all corners of the bond market. Faced with ultra-low yields from the highest quality bonds, investors will compete fiercely to secure the best deals elsewhere.

Ultimately, this competition serves to drive down yields in even the higher yielding segments of bond markets. For instance, given the inverse relationship between yield and price, US high yield bonds have risen in value by around 34% over the past five years.

Yields to rise?

Perhaps though, it´s time for investors to tread more carefully in bonds. Although official interest rates are still very low, the US Federal Reserve is already well advanced into its interest rate tightening cycle.

The other major global central banks will eventually follow suit and yields across the corporate segments of bond markets will ultimately rise as well. When that happens, bond prices will fall.

While there has been a significant rally in bond values over recent years, there is also scope for a hefty sell-off.