Owning a bond is essentially like possessing a stream of future cash payments. Those cash payments are usually made in the form of periodic interest payments and the return of 澳洲幸运5官方开奖结果体彩网:principal when the bond matures.

In the absence of 澳洲幸运5官方开奖结果体彩网:credit risk (the risk of default), the value of that stream of future cash payments is a function of your required return based on your 澳洲幸运5官方开奖结果体彩网:inflation expectations. This article breaks down bond pricing, defines the term "澳洲幸运5官方开奖结果体彩网:bond yield," and demon🎉strates how inflation expectations and interest rates determine the value of a bond.

Measures of Risk

There are two primary risks that must be assessed when investing in bonds: 澳洲幸运5官方开奖结果体彩网:interest rate risk and credit risk. Though our focus is on how 澳洲幸运5官方开奖结果体彩网:interest rates affect bond pricing (otherwise known as interest rate risk), a bond investor must also 😼be aware of credit risk.

Interest rate risk is the risk of changes in a bond's price due to changes in prevailing interest rates. Changes in short-term versus long-term interest rates can affect various bonds in different ways, which we'll discuss below. Credit risk, meanwhile, is the risk that the issuer of a bond will not make scheduled interest or principal payments. The probability of a negative credit event or default affects a bond's price – the higher the risk of a negative credit event occurring, the higher the interest rate investors will demand in exchange for as💦suming that risk.

Bonds issued by the 澳洲幸运5官方开奖结果体彩网:U.S. Department of the Treasury to fund the operation of the U.S. government are known as 澳洲幸运5官方开奖结果体彩网:U.S. Treasury bonds. Depending on the time until maturity, they are called bills, notes, or bonds.

Investors consider U.S. Treasury bonds to be free of default risk. In other words, investors believe that there is no chance that the 澳洲幸运🐻5官方开奖结果体彩网:U.S government will default 🃏on interest and principal payments on the bonds it issues. For the remainder of this articleꦗ, we will use U.S. Treasury bonds in our examples, thereby eli🐭minating credit risk from the discussion. 

Calculating a Bond's Yield and Price

To understand how interest rates affect a bond's price, you must understand the concept of yield. While there are several different types of yield calculations, for the purposes of this article, we will use the 澳洲幸运5官方开奖结果体彩网:yield to maturity (YTM) calculation. A bond's YTM is simply the discount rate that can be used to make the 澳洲幸运5官方开奖结果体彩网:present value of all of a bond's cash flows equal to its price.

In other words, a bond's price is the sum of the present value of each cash flow, wherein the present value of each cash flow is calculated using the same discount factor. This discount factor is the yield. When a bond's yield rises, by definition, its price falls, and when a bond's yield falls, by definition, its price increases. 

A Bond's Relative Yield

The maturity or term of a bond largely affects its yield. To understand this statement, you must understand what is known as the 澳洲幸运5官方开奖结果体彩网:yield curve. The yield curve represents the YTM of a class of bonds (in this case, U.S. Treasury bonds).

In most interest rate environments, the longer the 澳洲幸运5官方开奖结果体彩网:term to maturity, the higher the yield will be. This makes intuitive sense because the longer the period of time before cash flow is received, the greater the chance is that the required 澳洲幸运5官方开奖结果体彩网:discount rate (or yield) will move higher. 

Inflation Expectations Determine the Investor's Yield Requirements

Inflation is a bond's worst enemy. Inflation erodes the 澳洲幸运5官方开奖结果体彩网:purchasing power of a bond's future cash flows. Typically, bonds are fixed-rate investments. If inflation is increasing (or rising prices), the return on a bond is reduced in real terms, meaning adjusted for inflation. For example, if a bonಞd pays a 4% yield and inflation is 3%, t⛦he bond's real rate of return is 1%.

In other words, the higher the current rate of inflation and the higher the (expected) future rates of inflaꦛtion, the higher the yields will rise across the yield curve, as investors will demand a higher yield to compensate for infla💖tion risk.

Note that 澳洲幸运5官方开奖结果体彩网:Treasury inflation-p🥂rotected securities (TIPS) can be an effective way to offset inflation risk while providing a 澳洲幸运5官方开奖结果体彩网:real rate of return guaranteed by the U.S. government. As a result, TIPS can be used to help batt𝄹le inflatio🔥n within an investment portfolio.

Sh▨ort-Term, Long-Term Interest Rates, an🐈d Inflation Expectations

Inflation and expectations of future inflation are a function of the dynamics between short-term and long-term interest rates. Worldwide, 澳洲幸运5官方开奖结果体彩网:short-term interest rates are administered by nations' central banks. In the United States, the Federal Reserve's Federal Open Market Committee (FOMC) sets the 澳洲幸运5官方开奖结果体彩网:federal funds rate. Historically, other dollar-denominated short-term interest rates, such as LIBOR or LIBID, have bee🧸n highly correlated🅠 with the fed funds rate.

The FOMC administers the fed funds rate to fulfill its dual mandate of promoting 澳洲幸运5官方开奖结果体彩网:economic growth while maintaining price stability. This is not an easy task for the FOMC; there is always debate about the appropriate fꦯed funds level, and the market forms its own opinions on how well the FOMC is doing.

Central banks do not control long-term interest rates. Market forces (supply and demand) determine equilibrium pricing for long-term bonds, which set long-term interest rates. If the bond market believes that the FOMC has set the fed funds rate too low, expectations 🃏of future inflation increase, which means long-term interest rates increase relative to short-term interest rates – the yield curve steepens.

If the market believes that the FOMC has set theꦇ fed funds rate too high, the opposite happens, and long-term interest rates decrease relative to short-term interest rates – the yield curve flatt𒐪ens.

The Timing of a Bond's Cash Flows and Interest Rates

The timing of a bond's cash flows is important. This includes the bond's term to maturity. If market participants believe that there is higher inflation on the horizon, interest rates and 澳洲幸运5官方开奖结果体彩网:bond yields will rise (and prices will decrease) to compensate for the loss of the purchasing power of future cash flows. B♎onds with the longest cash flows will see their yields rise and prices fall the most.

This should be intuitive if you think about a present value calculation – when you change the discount rate used on a stream of future cash flows, the longer until cash flow is received, the more its present value is affected. The bond market has a measure of 澳洲幸运5官方开奖结果体彩网:price change relative to interest rate changes; this important bond metric is known as duration.

The Bottom Line

Interest rates, bond yields (prices), and inflation expectations correlate with one another. Movements in short-term interest rates, as dictated by a nation's 澳洲幸运5官方开奖结果体彩网:central bank, will affect different bonds with different terms to maturity differently, depending onꦺ the market's expectations of future levels of inflation.

The key to understanding how a change in inte♌rest rates will 🔴affect a certain bond's price and yield is to recognize where on the yield curve that bond lies (the short end or the long end) and to understand the dynamics between short- and long-term interest rates. With this knowledge, you can use different measures of duration and convexity⛦ to become a seasoned bond market investor.