How Economic Growth Affects Bond Performance
Economic trends are critical drivers of the bond market’s performance, but the economy affects bonds in various ways depending on their exposure to interest rate risk. Like other investment types, bonds are tied to the economy 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, and the influences they have on each other.
Economic growth occurs when a country's economy experiences an increase in the rate of economic output, referred to by economists as gross domestic product (GDP). GDP is the most commonly used measurement of an economy's performance. A positive change in GDP indicates economic growth, while a negative change indicates shrinkage.
Another measurement is gross domestic income (GDI). GDI measures income earned and costs incurred and is used in conjunction with GDP.
When the economy grows, the demand for money increases. More money is demanded because there are more products and services available. Consumers can spend more since the employment rate and wages generally rise with growth.
Interest Rate Risk
Interest rate risk means that bond returns vary based on the amount of fluctuation experienced in interest rates. The amount of risk added to a bond through interest rates changes depends on 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, which 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 yesterday might not be purchased for $1 a week from today. To combat inflation, the Federal Reserve (the Fed) uses monetary policy tools such as interest on required reserves, overnight reverse repurchasing, and the discount rate to influence the federal fund rate (which influences 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 since 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 make investors nervous, so bonds become more attractive to investors than stocks because of their fixed yields.
Growth Trends and Other Bond Market Segments
U.S. Treasuries are accepted by most analysts as benchmarks for bond performance. Thus, bond investors ultimately base their decisions on the returns of Treasuries.
Some types of bonds other than Treasuries benefit from stronger economic growth, rather than being hurt by it. Typically, these segments 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 on their performance.
U.S. Treasuries are used as benchmarks because they are the most reliably performing bonds.
Corporate bonds and emerging markets trade based on their credit ratings, which are driven by their underlying financial strength. The better these companies' balance sheets, cash balances, and underlying business trends, the less likely they are to default (miss a payment of principal or interest).
The lower the likelihood of a bond default, the lower the yield investors can accept as compensation for them taking on risk.
As a result, while stronger economic growth reduces returns on Treasuries and bonds, it is much more likely to be a positive factor for higher-yielding bonds where the issuer’s creditworthiness is a primary concern for investors. This difference helps make a case for diversification rather than concentration of 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.
- Bond prices rise as interest rates fall.
- Bond yields rise and fall opposite of prices.