THE BOND MARKET Frederick University 2014. The Bond Market Bond supply Bond demand Bond market equilibrium.

THE BOND MARKET

Frederick University2014

The Bond Market

Bond supply Bond demand Bond market equilibrium

Bond supply

bond issuers/ borrowers look at Qs 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 Qd as a function of bond

price/yield

Bond yield

Qd ofbonds

priceof 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

Qd

DD

a change in expected inflation rising inflation decreases real return

inflationexpected to

demand forbonds(shift left)

a change in exp. interest rates rising interest rates decrease value of

existing bonds

int. ratesexpected to

demand forbonds(shift left)

a change in the risk of bonds relative to other assets

relativerisk of bonds

demand forbonds(shift left)

a change in liquidity of bonds relative to other assets

relative liquidityof bonds

demand forbonds(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 ofbonds(shift rt.)

exp. economic expansion shifts bond supply rt. exp. economic expansion shifts bond supply rt.

a change in expected inflation rising inflation decreases real cost of borrowing

exp.inflation

supply ofbonds(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