Bonds and Interest Rates
We need to take a brief digression to understand the mechanics of bonds and interest rates. If you are not familiar with how they work, it will be confusing once we talk further about the Fed and how they control interest rates.
Bonds are assets that pay a fixed interest payment, usually every six months. In order to make the math a little easier however, we are going to assume they pay interest one time at the end of each year. Bonds are usually issued in $1,000 increments called the face value. If you buy one 10% bond, in this example, you will pay $1,000 and receive $100 dollars interest at the end of the year (again, in reality you would probably receive roughly $50 every six months). In addition, you will get your $1,000 back when the bond matures which, in this example, would be at the end of the year. Because you received $100 interest for $1,000 invested, your yield is $100/$1,000 = 10%, which is why this bond had a stated yield of 10%.
With just the basics of supply and demand we've covered, we can answer many questions about bonds. For instance, why do government bonds pay so little interest as compared to, say, corporate bonds? If we assume two one-year bonds, one government and one corporate, and both pay $100 interest at the end of the year and are both selling for $1,000, which would you rather have? Investors will prefer the government bond since it is guaranteed; it is possible for the corporate bond to end up in default (assuming it is not an insured bond).
Because investors will have a higher preference for the government bond – a higher demand – they willing to pay more for it relative to the corporate bond and will compete in the open market to buy it. Let's say the government bond is bid up to a price of $1,250. If you pay $1,250 for the government bond and receive $100 at the end of the year, your yield is now $100/$1,250 = 8% instead of the 10% you can get with the corporate bond. The markets will price all bonds (in fact, all assets) to reflect all risks. The less risky bonds have their prices bid up relative to riskier bonds and consequently have lower yields. As we will see shortly, bond prices move in the opposite direction of interest rates. Generally the government bonds are considered to be the risk-free rate and all other bonds are priced lower (higher yields) according to their risk.
Now let's assume the risk-free interest rate falls from 8% to 6%. What happens to the price of the bonds? Think about the incentives to investors. Assume you want a government bond, currently priced to yield 8%. If you are going to buy a government bond, you can either buy the existing bond in the market and earn 8%, or you can buy a newly issued bond and earn 6% (you will only receive $60 at the end of the year instead of $100). Which do you choose? Obviously, the 8% bond is more attractive to you so you would want to buy it. But, wait – so will all other investors!
Remember, they are thinking the same thing as you and will compete for that bond and bid up the price. If you bid $1,300 for it, your yield would be $100/$1,300 = 7.7%, which is still better than the new interest rate of 6%. Other investors will realize that it is still a better deal to hold the 8% bond and continue to compete for the bond. Eventually, the bond will be priced at $1,666, which gives a yield of $100/$1,666 = 6% and there is now no incentive to compete for the 10% bond. Whether you buy the new 6% bond for $1,000 or the former 10% bond for $1,666, you are no better or worse off. Both bonds have reached price equilibrium. The important thing to understand from all of this is that there is an inverse relationship between bond prices and interest rates:
As interest rates fall, bond prices rise.
The same reasoning works in reverse too. If interest rates rise to 12%, investors will prefer to buy the new 12% bonds (and receive $120 at the end of the year) and not the 10% or 8% bonds that exist in the market. Because of this, any of the investors who want to sell their 10% or 8% bonds must give buyers an incentive to buy – they must lower the price. The 10% bond owners will quickly be selling for $833 and any investor paying that amount will yield $100/$833 = 12%. Similarly, the 6% bond will be selling for $500, giving investors a yield of $60/$500 = 12%.
It is important to understand these relationships with bonds and interest rates. The reason, as we shall see, is that the Federal Reserve can buy and sell bonds in the open market, thereby influencing interest rates. The Fed can control the supply of money by raising or lowering rates thus influencing your demand for money. Understanding the Fed and bond mechanics demonstrates how your demand for loans can be influenced. If you remember from our previous discussion of supply and demand, you hopefully remember that you shouldn’t analyze one force without the other. So let’s ask the question, “Is there anything that can affect the supply of money?” The next section provides the answer.