29 Apr 2024
The returns of a bond are composed of coupon income and price changes. A key metric of bond markets is the bond yield, which moves inversely with bond prices. When yields rise, bond prices fall assuming all factors unchanged. Factors driving yields include changes in credit ratings and interest rates.
A yield curve is a line that plots yields (i.e. annual rate of return till maturity) of bonds with equal credit ratings but different maturity dates. There are generally three types of yield curve – 1) upward sloping;
2) downward sloping or inverted; and 3) flat.
When an economy is growing, we should see an upward sloping yield curve with longer-maturity bonds offering higher yields to compensate bond investors for the additional volatility associated (e.g. interest rate risk). A downward or inverted yield curve likely indicates an economic downturn, as investors expect lower interest rates to be implemented to stimulate economic growth. A transition between these two scenarios could result in a flat yield curve.
The interest rates set by central banks are a key input in a company’s or a government’s cost of borrowing. When inflation falls, central banks tend to decrease interest rates to stimulate economic activity and encourage increased spending. In such a disinflationary environment, bond yields tend to decrease with lower costs of borrowing, companies will also speed up investments and production. The situation will reverse in an inflationary environment where central banks are inclined to raise interest rates to cool down the overheated economic.
Duration, expressed in the unit of years, measures the sensitivity of bond prices to interest rate movements. The longer the duration, the more sensitive the prices to interest rate changes. Shorter-term bonds (i.e. up to 5 years) are generally more resilient to interest rate fluctuations than longer-term bonds.
For example, when interest rates rise by 1%, bond prices will drop by somewhat below 2% and 4% for a bond with a 2-year and 4-year duration respectively. Conversely, when interest rates fall by 1%, a bond with a 2-year duration will experience a gain in value of approximately 2%, while the price of a bond with a duration of 4 years will increase by approximately 4%, with other things being equal.
Source: HSBC Asset Management. For illustrative purposes only, with all other factors assumed to be equal.
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