Updated 2023-03-30

 

Bond yields are significantly affected by monetary policy, specifically FED imposed interest rates.

Fed Funds Rate has the effect of changing the overnight lending rate that banks use to borrow and lend money to each other. An increase in the Fed Rate, means that it costs more for banks to borrow funds from another bank. 

 

A bond’s yield is based on the bond’s coupon payments (how much the monthly payments for holding a bond are), divided by its market price.

 

We’ll go over some examples here using simple math and neglecting bond duration. Please note that a bond’s duration is very important in pricing, however the pricing dynamics are similar and easier to grasp this way. 

 

Example of Bond Yield Pricing

 

Bond X

Bond Market Price: 100 USD

Term: 10 Years

Monthly Bond Coupon Payment: 5 USD

 

Monthly Bond Coupon Payment / Bond Market Price = Bond Yield

5 / 110 = 5%

Bond Yield = 5%

 

As bond prices increase, bond yield’s decrease.

Using our previous example, a Bond Price increase to 150 USD would mean the following:

5 / 150 = 3.3% 

Bond Yield = 3.3%

 

So with FED interest rate changes the bond prices on the secondary market rise or fall, affecting an existing bond’s yield.

Decreasing interest rates make bond prices rise, and bond yields fall.

The converse is true; rising interest rates cause bond prices to fall, and bond yields rise.

 

How Fed Rates Affect Bond Prices

Bond Yields can be considered interest, with the coupon payment being assessed similar to interest payments from a standard loan. 

 

When investors (building up the market) look to see how a bond is valued, they compare a bond’s yield to other similar investment vehicles. 

In a secondary market, this comparison analysis can change how a bond is valued, affecting its price when sold, either at Par (the same or similar price), a gain (premium), or a loss (discount).

 

Example of Valuing a Bond at Issuance

 

We’ll use a bond example that was purchased from the Treasury at issuance.

 

Bond A

Bond Price at Issuance: 100 USD

This is also the face value of the bond, with the yield matching the coupon rate of the bond.

 

In this example a bond yield of 1% will have a monthly coupon (payment) of  1 USD.

Monthly Bond Coupon Payment: 1 USD

 

Using the formula to determine bond pricing, you’ll see how this is confirmed:

1 / 100 = 1%

Bond Yield = 1%

 

Example of Valuing a Bond in the Secondary Market

 

Let’s imagine a scenario where a similar bond type is issued by the Treasury, however the Fed Rate has increased. What would happen is that the yield for this bond would have to increase to match or surpass this Fed Rate (simply put).

 

A new bond being issued may have a 2% yield for the same face value. 

 

Bond B

Bond Price at Issuance: 100 USD

Monthly Bond Coupon Payment: 2 USD

Bond Yield = 2%

2 / 100 = 2%

 

Let’s review how this affects the value of the previously referenced Bond A in the last example. 

If an investor can purchase a bond to get a 2% yield, that is what they expect from bonds sold on the secondary market. And the only way for a holder of Bond A to meet this yield would be to sell the bond at a discount. 

 

Bond A

Bond Price at Issuance: 100 USD

New Price offered to Secondary Market: 50 USD

This has to be adjusted to match the expected yield of 2%

 

Monthly Bond Coupon Payment: 1 USD

This stays the same, since it’s the set bond coupon rate that the treasury will pay no matter what. 

 

New Bond Yield = 2%

2 / 100 = 1%

 

Here you can see that the only way to liquidate this bond would be to sell it at a discount, or else no one would buy it when a new bond offering will provide a higher yield. 

 

 

Bond prices on a secondary market also include other ideas like credit risk, duration, and other important economic factors.

Bond’s are great investment vehicles for steady safe yield, yet when sold on a secondary market it can get a little more complex. It is almost always recommended to try and hold a bond till maturity to realize the face value, and not be exposed to secondary market risk.