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 so bond supply slopes up with price

Bond price Q of bonds S

Bond Demand bond buyers/ lenders/ savers look at Q d as a function of bond price/yield

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

Bond price Quantity of bonds D

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

Wealth Higher wealth increases asset demand Bond demand increases Bond demand shifts right

P QdQd D D

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

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

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

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

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

Shifts in bond supply Change in government borrowing Increase in government borrowing Increase in bond supply Bond supply shifts right

P Qs S S’

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

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

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

Example 1: the Fisher effect expected inflation 3%

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

bond price falls interest rate rises

Fisher effect expected inflation rises, nominal interest rates rise

Example 2: economic slowdown

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

shift Bs > shift in Bd interest rate falls shift Bs > shift in Bd interest rate falls

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

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

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

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

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