A bond is a loan made to a corporation or government in exchange for regular interest payments. The bond issuer agrees to pay back the loan by a specific date. Bonds can be traded on the secondary market. The bond market is usually where investors venture when looking for stability, security, and a lower risk profile as a part of their investment portfolio.
What happens in the bond market has real implications for equity investors and for the economy in general. A bond essentially represents an IOU—a promise to repay a loan on a certain date, along with specified interest payments along the way.
Prices and interest rates for an individual bond depend on a variety of factors, including positive or negative news about the issuer or changes in its credit rating.
But at a higher level, returns in the bond markets are much more related to interest rate changes—and perceptions about what will happen to interest rates in the future. When interest rates fall, the prices of existing bonds go up. And when interest rates rise, the opposite happens: If your loan is earning you less money than someone could make by giving a brand-new loan, they’re going to pay less to buy your loan. This creates volatility in the bond market.
However, the volatility seen in the bond market in the recent short term hasn’t been seen in decades.
Volatility has returned to the bond sector. And, some of the “rules” that have held true in the bond market for decades have been overturned. For example, early last month in March 2023, the year U.S. Treasury bond yield briefly ticked above 5%, which is the highest it had been in more than 15 years. A couple of weeks later it was back below 4%.
In early March, Fed Chair Jerome Powell stated in testimony before Congress that the peak Fed Funds Rate was likely to be higher than many initially expected, explains Collin Martin, director and fixed income strategist, Schwab Center for Financial Research. And when Powell suggested that, investors began to act, and they sent up treasury yields to where they expected the Fed Funds Rate to reach down the road. Now, like most investments, yield comes down to supply and demand. And following the comments from Powell, treasury investors demanded higher yields then, in the short term, so that they weren’t stuck holding investments with lower yields if the Fed did hike more than they initially anticipated.
The dynamics changed pretty suddenly with the collapse of Silicon Valley Bank pulling down yields sharply, because of concerns about financial stability, Collin stated.
Now, the Fed has a dual mandate of price stability, which can be considered inflation, and maximum employment. But the Fed also has an unofficial mandate of financial stability, and the collapse and failure of a few banks led to concern that stability could deteriorate.
So investors totally shifted their expectations for Fed policy, and instead of expecting a peak rate of 5-1/2% or more, expectations were that the peak rate might only be 5% or so. In fact, bpnd investors weren’t even sure if the Fed would hike at all going forward, and they began to price in rate cuts sooner than expected. Now, if the Fed was only expected to hold its rate at 5% or so, and then cut it soon, investors pulled down those expectations and were willing to accept a lower yield and lock in that lower yield for certainty rather than risk what happens if the Fed cuts rates down the road. And that’s what pulled their prices up and yields down because of those expectations.
References:
- Volatile Bond Market Signaling Changes to Economy podcast transcript, Charles Schwab WashingtonWise, April 6, 2023.
- https://investor.vanguard.com/investor-resources-education/portfolio-management/bond-markets#modal-bond