Economic trends are critical drivers of the bond market’s performance. But the economy affects bonds in many ways; it depends on their exposure to interest rate risk. Like other investment types, bonds are tied to the economy. That's because the businesses and governments that issue them exist within that economy.
Bonds affect the economy, and the economy affects bonds. Here's how they are related as well as how they impact each other.
How Economic Growth Works
Economic growth occurs when a country increases its rate of economic output. This is known as gross domestic product (GDP). GDP is the most commonly used measure of an economy's performance. A positive change in GDP means economic growth; a negative change means shrinkage.
Gross domestic income (GDI) measures income earned and costs incurred. It is used in conjunction with GDP.
When the economy grows, the demand for money rises. More money is demanded because there are more products and services available. People can spend more since the employment rate and wages often rise along with growth.
Interest Rate Risk
Interest rate risk means that bond returns vary based on the amount of fluctuation in interest rates. The amount of risk added to a bond through interest rates changes depends on a few factors: how much time until the bond matures, the bond's coupon rate, or its annual interest payment.
The longer you hold a bond, the more risk you accept. This is due to the chances of interest rates being lower when you try to sell your bond. That can make it less attractive to other investors. You might even end up selling your bond for less than the price you paid.
How Economic Growth Impacts Bonds
Higher currency demand causes inflation, which is the reduction of a currency's purchasing power. In other words, an item worth $1 today might be worth less than $1 a week from now To combat inflation, the Federal Reserve (the Fed) uses monetary policy tools. These include interest on required reserves, overnight reverse repurchasing, and the discount rate. These tools help influence the federal fund rate; this then impacts interest rates.
When interest rates rise, bond prices fall. When interest rates fall, bond prices rise. Bond yields rise when interest rates rise and drop when rates fall.
Rising interest rates can make investors more interested in stocks because bonds sell for less. Slower economic growth reduces the demand for money. That's because individuals and businesses are less likely to take out loans to finance projects and purchases.
Lower demand for loans causes prices and interest rates to fall. Falling rates may make you nervous as an investor. Bonds become more attractive than stocks because of their fixed yields.
Growth Trends and Other Bond Market Segments
U.S. Treasurys are considered benchmarks for bond performance. Thus, if you're a bond investor, you may base some of your decisions on the returns of Treasurys.
Some types of bonds other than Treasurys benefit from stronger economic growth, rather than being hurt by it. These segments often include high-yield bonds, emerging markets bonds, and lower-rated corporate bonds. The yields on these bonds are high enough that modest fluctuations in Treasury yields have less of an impact.
U.S. Treasurys are used as benchmarks because they are very reliable.
Corporate bonds and emerging markets trade based on their credit ratings. Credit ratings are driven by their financial strength. The better their balance sheets, cash balances, and business trends, the less likely they are to default. Defaulting means missing a payment.
The lower the chance of a bond default, the lower the yield you can accept in exchange for them taking on risk.
A stronger economy lowers returns on Treasurys and bonds. But it is much more likely to be a positive factor for higher-yielding bonds where the issuer’s creditworthiness is a major concern.
This difference helps make a case for diversification. It's a better option than concentrating your holdings in any one segment of the bond market.
- Economic performance affects interest rates.
- Interest rates affect bond performance.
- Bond prices fall as interest rates rise, and prices rise as rates fall.
- Bond yields rise and fall opposite of prices.