Hi all,
I get that there is an inverse relationship between bond prices and interest rates. However, the FINRA exam I just took would not such an easy question in such a straight forward format.
Instead (as I remember it), the question asked what would happen to bonds in a high inflation environment. I was able to get down to two answers: one that bond prices would go down and the other that bonds would get redeemed.
My rationale for the first answer: if inflation is high, bonds, particularly long term bonds, would yield less purchasing power. Therefore, the prices of bonds would go down.
However, on the other hand, if the current environment has high inflation, that would indicate to me that interest rates are currently low. Therefore, bonds may be redeemed in such an environment so that issuers can refinance at the lower rate.
So, what is the right answer, please?
Thanks.
Generally, it's a chicken and egg problem (maybe phrased a bit differently)... I have much more sympathy for the former argument. The latter argument makes very little sense.
Thanks. It's funny, that is how I viewed it as well, "chicken or egg". It seems a bit arbitrary to me. Considering I chose the second answer, I probably got the question wrong. Oh, well, I still passed. But, would be interested to know if there is a definitive answer.
There isn't a definitive answer. The subject is much argued amongst the academics, especially recently. Again, the arguments are all a bit different to the ones you're referring to, but the causality is a bit of a muddle.
I too thought the same. However, a related question that I have is are all bonds callable? As in, if a bond is not callable then can the issuer redeem the bond and refinance it?
Some bonds are callable, but why complicate matters?
Assume they're not callable, but, if rates are sufficiently low, an entity can just issue more bonds. Some issuers can specifically do "exchange auctions", where they buy some of their particular bonds in the market at the prevailing price, in exchange for some other bonds.
Its not in the text books, but I don't like them asking about inflation. Inflation the bonds could actually go either way. I'd prefer they ask about NGDP.
Take a situation where inflation is high and society say suffered a natural disaster. So you have 30% inflation and 40% fall in real gdp. (this is extreme and unlikely, but possible). It would be fairly difficult to judge what price bonds would trade at. Everyone is obviously poor, but if you are allocate assets what are you buying - equities (nope), cash (maybe same as bonds but no yield), or bonds. I'd argue bonds would rally in that situation.
More likely you could have a mild recession of -2% gdp growth with a minor supply shock causing inflation to pop a little....same situation just more modest numbers.
By redeemed, I assume you mean called. If I issue debt and inflation rises, I will not refinance at this time as inflation works in my favor
Yes, I understood the answer to mean that the bonds would get called. However, my understanding now is that inflation is rising, most likely interest rates will also rise to combat that inflation. Therefore, bonds will not be recalled and in fact the prices of bonds will go down.
Thanks for the reply.
This is one of those cases where the obvious answer is also the correct one: in a high inflation environment, bond prices will decline.
Even before the reasoning, I really recommend you commit the phrase "bonds hate inflation" to memory. It's one of the useful ones. Sure, you could come up with (pathological) cases where this doesn't hold, but that's not what you were asked to do.
Let's (for a moment) forget the concept of interest rates. A bond is a claim on a stream of fixed cash flows in the future. In a high inflation environment, the attractiveness of these fixed cash flows declines. The claim on them will therefore command a lower price.
To be precise, what matters is not current, but rather expected inflation over the remaining life of the bond. If you bought a 10y bond 5 years ago, all you are going to care about now is what inflation will be over the next 5 years. The reason is exactly what you mentioned: the purchasing power of a fixed cash flow is determined by the cost of goods/services/whatever when the cash is received.
By the way, the impact of current inflation (i.e., how much are today's prices higher than 1y ago) on bond prices is limited to the extent to which current inflation informs and affects expectations of future inflation. This is usually meaningful. That is why bonds hate inflation.
That is really all you needed to answer the question correctly. Now I don't like your second theory, I don't think it makes much sense as Martinghoul pointed out -- but that's not important! You thought that it is correct, perhaps as correct as your first theory. You will find yourself in this situation again, over and over: two competing theories that you like. I would defer to Occam's Razor: when two hypotheses explain a phenomenon equally well, prefer the one that makes fewer assumptions.
Your second explanation is full of assumptions. You assume that the level of inflation determines the level and path of interest rates. You assume that the level of interest rates determines corporates do. The second one makes more sense, but again this isn't important. Say that your assumptions were correct and your second theory explains the impact of inflation on bonds just as well as your first. You still have to go with the first one --> it assumes less, it is simpler.
"Bonds hate inflation". Got ya. Yes, I believe I overanalyzed the question when the answer was right in front of me. But, I guess the test makers anticipated this analysis, which is why they placed the red herring of a question in the first place.
Thanks for this. Follow up question for corporate fixed-rate instruments, though: What do you make of the argument that - acknowledges that the expected real value of the coupon stream becomes lower for the investor who then demands higher yields, BUT - insists that the expected interest burden for the company, in real terms, is also lower, thus reducing credit risk and acting as a countervailing force? I.e., with a 2% increase in expected inflation across the curve, for example, a company can be expected to reduce its real interest burden by 2% in every period.
Where am I going wrong? Or is it just the case that the 2% decrease in interest burden isn't countervailing so much as barely offsetting, or stated differently, that the credit risk premium isn't enough to offset the inflation discount?
Here, I assume nothing about inflation levels or a change in growth expectations. It does, however, make the assumption that the company's prices and costs move in tandem with economy-wide inflation.
This is a really interesting question, and I don’t know if I’m right. Here are my thoughts - at the very end of your comment you state that one of the assumptions is that prices and costs move in tandem with economy wide inflation. Thus the incremental demand for goods would decrease, and the incremental cost of production would rise. This in turn would increase the risk premium demanded by the market (Higher costs, lower demand), thus offsetting the REAL decrease in credit default risk that the incremental increase in inflation causes for fixed rate corporate instruments. So the inflation discount WOULD prevail over the risk premium, which in turn would justify the incremenfal benefit for the issuer in this case - like I said, just my thoughts on the question.
The impact of the credit-enhancement should be minimal. Now this is a fair topic to examine for the sole purpose of satiating your own curiosity. No interviewer will EVER ask the OP's question and have ANY desire of hearing you blab on about this stuff (regardless of whether they share your curiosity). That said, I'll give you my take on this at the end.
At the risk of repeating myself, I really want to drive this point home. If you are asking these types of questions on WSO, you are likely on the hunt for entry-level positions. Given this, here are things your interviewers / exam-writers are actually curious to know:
Does this candidate have a good grasp of basic economic concepts? Does he get the relationship between the present value of a stream of cash flows and the purchasing power of those cash flows?
Can this candidate follow a train of thought, understand what being asked, and answer a simple question without a question?
In other words, does this person "get it"? If I end up managing them, and I ask a question that isn't perfectly worded, will they take the right cues from context and come up with a succinct & relevant response, or will they try to be clever and ask me 10 follow-ups that completely miss the point?
Back to your question. The net impact would depend on the riskiness of the bond. It would hardly matter at all for low-medium risk bonds; and it might matter a lot for very high-risk bonds.
You've got two opposing forces, probability of default and PV of payment (if paid). An uptick in inflation definitely decreases the PV if paid, but could potentially improve likelihood of payment. So which dominates?
Let's imagine a low risk bond, issued by a firm whose debt service costs are dwarfed by its ability to generate free cash. The probability of default is pretty damn low, let's call it 5%. Ceterus paribus, even a large change in inflation expectations would hardly move the needle on this (the firm already generates more than enough to service all debt). Let's say it goes from 5% --> 4.5%
Now take a highly risky bond, say one that's priced to default. Let's be fanciful and imagine that the marginal impact of higher inflation on the the firm's free cash is exactly what was needed to make good on their next payment. In this case, probability of default would shift more meaningfully, let's say from 55% --> 50%
Can you tell which will have a higher impact on the bond's price? A useful way to think about bonds is the Merton model. A long position in a bond is like a short position in a put option on the firm's assets, struck at the face value of outstanding debt. The value of a low-risk firm's assets exceeds the face value of its debt by leaps and bounds. In that sense, the low-risk bond is like a very far OTM option -- it has a very LOW DELTA. The value of the high-risk firm's assets might barely exceed its debt --> it is in this sense a much HIGHER DELTA option.
This is generally why Investment-Grade credit spreads tend to be a lot less sensitive to the underlying cash flows of the firm, and much more sensitive to the overall level of risk-premium in the market. High-Yield spreads, on the other hand, are more dependent on the underlying cash flows.
You didn't make it clear how the question was actually worded. But in general, a lot of people get this type of question wrong. A lot of experienced people get this wrong.
In a nutshell, it depends on what is priced into the bonds already and then how realized inflation comes in relative to that. That is, the level of inflation isn't what really matters.
Bonds, like equities, discount future conditions. A company can announce record earnings, but if even higher earnings are expected, the equity will go down. Likewise, if very high inflation is already priced into the bond, then if inflation comes in lower than that, the bond will go up in price, even with a high level of inflation.
So to repeat, what matters is what is realized relative to what is discounted.
For some reason, and I've seen this for years, people can't seem to wrap their head around this concept.
There's no clear relationship between interest rates and inflation. You can have an increase in interest rates in a deflationary environment (i.e., when there's a panic and an increased demand for cash holdings). You can have higher interest rates in an inflationary environment (when investors demand a higher nominal return to protect their real, risk adjusted return). You can have a decrease in interest rates in a deflationary environment (i.e., when there's an increase in the supply of loanable funds/savings).
There are so many variables here but your first answer is a good one.
If the question is worded how you say, then I read it as "what is going to happen to bonds in a high inflation environment" rather than "what is currently happening to bonds in a high inflation environment". Of course there are much more variables to consider, like Esuric said, but in general, I believe that the first answer is the only correct option. As a public finance analyst, these concepts are hammered into our head.
In a high inflationary environment, the FED will be begin to pursue a "tight" monetary policy - meaning that they will take certain measures to ease the availability of credit in the economy (by purchasing securities in the open market, raising the discount rate/reserve requirements, etc.). This will, in turn, decrease the amount of funds available for banks to loan out, increasing interest rates due to the laws of supply and demand.
As you already know, this will cause the yields of bonds to increase while their prices decrease (answer #1). If the yields of currently issued bonds are increasing, issuers will not try to refinance their outstanding debt, because it will be more costly. However, it is possible that they could repurchase their debt in the open market because the prices have decreased.
Either way, its an unfair question.
Bonds and Inflation (Originally Posted: 03/09/2011)
Hello I have a few pretty basic questions about bonds and inflation. I am currently reading Intelligent Investor and in Chapter 2 where it discusses how bonds have been labeled has a bad investment when inflation rates go up. Is this because when inflation goes up and lets say you have a medium term high grade bond for lets just say $1000 and inflation goes up is this bad because if you wait for the maturity and the payment in three years and lets just say you get back $1110 then that money is now not that great of return because the cost of living as gone up? And also what if you bought a high grade bond prior to a rise in inflation and bond prices go up. Would this not be beneficiary because then you could sell your bond and make a profit? I am a little puzzled on these two scenarios and I apologize if i did not thoroughly explain my question but if I did an answer to these questions would be very appreciated. Thank you. Also I was wondering on any other things I should read for a beginner of investing.
inflation=interest rates rise= new bond yields rise= old bond prices fall
i believe...
Is it because of the fixed dollar amount on a bond kind of like if you have fixed income amount then you get hit hardest by an increase in the standard of living?
as inflation rises, the interest payments you receive over the life of the bond are worth less as the bond matures. (Fixed income)
Your first reason is correct. More clearly, inflation goes higher, it means your adjust real return on the bond become lower. Your bond is less attractive to hold in the new scenario, which cause your bond price go lower, NOT higher. Therefore second part of your reason is not correct. Think from a different angle, if the inflation is higher, the bond investor will demand higher interest rate in the newly issued bond, which means higher yield. Higher yield means lower price.
I surmise the book probably said the yield goes higher, not price. If you have coupon bond with par value, higher inflation means you will discount your cash flow with a higher yield, which mean lower price.
Your first reason is correct. More clearly, inflation goes higher, it means your adjust real return on the bond become lower. Your bond is less attractive to hold in the new scenario, which cause your bond price go lower, NOT higher. Therefore second part of your reason is not correct. Think from a different angle, if the inflation is higher, the bond investor will demand higher interest rate in the newly issued bond, which means higher yield. Higher yield means lower price.
I surmise the book probably said the yield goes higher, not price. If you have coupon bond with par value, higher inflation means you will discount your cash flow with a higher yield, which mean lower price.[/quote]
This is the correct answer. To sum this up you need to understand the time value of money. This says that a dollar today is worth more than a dollar tomorrow. Why? Do a search on google about time value of money and if you have questions someone here will help you out. (Discounted cash flow would help this concept as well).
An important distinction to make between bonds is between the coupon payment (fixed payment you will receive) versus the yield to maturity. The yield to maturity (YTM) is market driven by things like inflation, perception of security versus stocks and other investment vehicles, other factors. As the YTM rises your coupon payments (remember what you will receive) are worth less in today's present value. A good way to think of this is if one day I have a 5% coupon and 5% YTM meaning my bond is priced at par (when coupon=YTM) and the NEXT DAY the YTM rises to 6% (we will assume coupon won't change for this basic example) then you lose money. Before you had 5% coupon and 5% YTM. Now you have 5% coupon and 6% YTM. Really you would prefer a 6% coupon and 6% YTM right? Since you now don't have that you're kicking yourself and would prefer the higher coupon rate. See the difference?
Another link about bond prices and yields is on investopedia.
http://www.investopedia.com/university/bonds/bonds3.asp
All right that makes a lot more sense thank you too both. I didn't fully understand the distinction between the coupon payment and the YTM and that you are locked in when you buy a bond. Thank you again
Not for simplicity we say that coupon is fixed. However there are step up bonds where coupon payments that do fluctuate. Also many other types of bonds that are not your typical coupon payments for instance zero-coupon bonds. In the example I gave you we assumed a fixed rate coupon payment. Like I mentioned it might help to review discounted cash flow and concept of time value of money if you still have trouble.
For interest- http://www.investopedia.com/terms/s/stepupbond.asp
Another reason why people like to invest in equities.. they have MUCH less inflation risk than fixed investments such as bonds.
You have all types of different risk with bonds. -Interest Rate Risk -Inflation Risk -Default Risk -Reinvestment Risk
Interest Rate Risk This is the risk that interest rates will rise and the price of your bond will fall. This is because treasury bonds will sell @ the discount rate. So if you have a 5% coupon bond and the yield is 6%, your bond is worth that much less in resale value. Interest rate risk is simply RESALE VALUE RISK.
Inflation Risk Like interest rate risk, if inflation occurs, your bond is worth less. Fixed investments don't cope well with inflation.
Default Risk The risk that the issuer will not be able to repay the principal.
Reinvestment Risk If a bond is a callable, there is a risk that the issuer can recall the bond if interest rates drop. This means that the issuer would cancel any further interest payments and pay you the principal+a small premium for calling the bond early. In essence it's like 'calling the bond off'. After this, you as the investor is succeptable to reinvestment risk, because you can only reinvest at a lower interest rate, since rates have dropped.
Hope that helps also.
Although you mention that people invest in equities because they have much less inflation risk it's important to note that bonds and equities are completely different in many ways. Bonds have a maturity unlike equities. That is to say that should someone never sell equity he/she will never make any money (minus a dividend payment). Yes someone can say "my stock portfolio is up 20% since I've been trading". However, when you consider that you are not guaranteed a stream of income and most "normal" investors are risk-averse and will sell on an equity downturn the rate of return might even be lower than a bond. Say you are up "20%" on your portfolio having traded for 6 months when suddenly your portfolio falls 14% due to a market disturbance. You respond by getting locking in a profit of 6%. Great, except you'll have to pay short term capital gains tax so your 6% gain is further diminished. Say that you invested in a tax-exempt muni bond of 4.5%. You could be collecting this solid coupon rate tax-free. Something to think about.
its pretty simple...when you buy a bond you dont get your principle back until the bond matures. in an inflationary environment that principle will be worth alot less by the time you get it back. So inflation is bad for bondholders and the longer the duration of the bond the worse it tends to be.
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