Wednesday, January 4, 2017

Bond Basics: Part 4

I had planned to start digging into the mathematical formula that relates bond price and bond yield in this post, but first I want to discuss one more example related to the topic discussed in Part 3 of this series. In that part, I explained that we can't make precise statements about the general relationship between interest rates and bond prices, because the yield (and price) of each bond changes differently depending on the bond market's assessment of the term risk and credit risk of that particular bond. Confusion about this is often exposed by questions about the impact of increases to the federal funds rate (FFR) on the prices of bond funds. So following is a brief discussion of this, and then in Part 5 I'll pick up on deriving the formula for bond pricing.

If you follow financial news at all, you have heard that the Federal Open Market Committee (FOMC), often referred to simply as the Fed, recently increased the target federal funds rate by 25 basis points (0.25 percentage points), and that they intend to increase the target FFR several more times in 2017. A common question on the Bogleheads investment forum is how increases in the FFR will affect the share price of a bond fund owned by the forum member.

The short answer is that changes in the FFR are not of particular concern, since the FFR is a very short-term interest rate, and as discussed in Part 3, yields of different terms to maturity can change by different amounts and even in different directions. There is no direct relationship between the change in the FFR and the change in yield of an intermediate-term or long-term bond or bond fund.

A dramatic example of this was the period between May 10, 2004 and September 1, 2005, during which the effective FFR increased from about 1% to about 3.5%, while the yield on the 10-year Treasury decreased from about 4.7% to about 4%. This is shown in the chart below.

(If you have any trouble viewing the charts while reading this in your email, click on the blog title link, which should take you directly to the blog where you should be able to view the charts).

Note however that the yield on the 1-month Treasury, also shown in the graph, closely tracked the effective FFR, since both are short-term rates. Similarly, you can expect the yields on money market funds, which also are very short-term rates, to have a close relationship to the FFR, but the yields of intermediate-term and long-term bonds and bond funds can change very differently than changes in the FFR.

As a more recent example, the Fed increased the FFR by 25 basis points in December 2015, but the yield on the 10-year Treasury decreased from about 2.3% at that time to about 1.4% in early July of 2016.

I think of Fed changes to the FFR more as responding to the economy rather than driving bond yields, other than very short-term bond yields. It's the economy that drives interest rates in general. It's not particularly surprising that intermediate-term bond yields could be increasing at the same time the Fed increases the FFR, since both are related to prospects of the economy strengthening, but this doesn't mean that an increase in the FFR causes an increase in bond yields in general.

Consider the period since shortly before the recent presidential election until now, as shown in the chart below. The yield on the 10-year Treasury gradually increased while the effective FFR was flat at about 0.4%. Then on November 9, the day after the election, the 10-year yield jumped from 1.88% to 2.07%, and then continued to climb, while the effective FFR remained flat at about 0.4%. On December 15, the effective FFR jumped to 0.66%, consistent with the increased Fed target of 0.5% to 0.75%, and although the 10-year yield also increased slightly that day, within a few days it was back down to its level before the FFR increase.

Although there are reasons to be concerned (or perhaps happy) about rising intermediate-term bond yields, what the Fed does with its target for the FFR is not one of them. Bond yields will increase, and prices will fall, if the economy strengthens and inflation expectations increase, and the Fed is likely to increase the target FFR due to the same factors. Correlation does not imply causation, and as we've seen, sometimes bond yields aren't even correlated to changes in the federal funds rate.

1 comment:

1. Glad to know the basics of bond which I dint know before.Specially the mathematical relation between bond price And bond yield is the thing which is known by the few people only.