How Economic Growth Affects Bond Performance

businessman pointing at a graph showing the movement in the bond market
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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 state of 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 as well as how they impact each other.

How Economic Growth Works

Economic growth occurs when a country increases its rate of economic output, which 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.

Note

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 rate 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 risk only applies to investors who do not hold the bond to maturity. If you decide to sell the bond to a third party before maturity, then the fluctuation of interest rates matters. If interest rates have risen since you first bought the bond, then you will likely have to sell it for less than you paid for it in the first place. That’s because bond prices and interest rates are inversely related.

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 funds rate, which then impacts interest rates.

Important

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 to fall and interest rates to rise. Bonds can then 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.

Note

U.S. Treasurys are used as benchmarks because they are very reliable.

Corporate bonds and emerging markets trade based on their credit ratings, which are driven by their financial strength. The stronger their balance sheets, cash balances, and business trends, the less likely they are to default (miss a payment).

The lower the chance of a bond default, the lower the yield you can expect. Investors require a higher yield when the chance of bond default is elevated, but they are willing to accept less if the chance of default is remote.

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 wiser option than concentrating your holdings in any single segment of the bond market.

Key Takeaways

  • Economic performance affects interest rates.
  • Interest rates affect bond performance.
  • Bond prices fall as interest rates rise, and vice versa.
  • Bond yields rise and fall opposite of prices.

How Do Market Interest Rate Fluctuations Affect a Bond's Coupon?

Regardless of how the broader market fluctuates, a bond's coupon remains consistent (unless the bond is inflation-protected). The coupon is the dollar value of the payments you receive. As the bond market fluctuates, the price of your bond may rise or fall. If it rises, then the yield rate will decrease, because the coupon doesn't increase in step with the bond price. This doesn't significantly impact bondholders who plan on buying and holding bonds until maturity.

Is a Recession Good for Bonds?

During a recession, interest rates typically fall as demand for new borrowing dries up. Because bond prices are inversely related to interest rates, this suggests that bond prices will rise during a recession. Note, however, that bond prices are also sensitive to credit and default risk, so if a recession also harms borrowers' ability to repay, it can hurt bond prices.

What Is the Green Bond Market?

Green bonds are bonds issued to finance sustainability projects. They can be issued by entities around the world, from the World Bank to developing nations to local municipalities in the U.S.

Article Sources

  1. Federal Reserve Bank of New York. "Federal Funds and Interest on Reserves." Accessed Jan. 24, 2022.