 Personal Finance PowerPoint Presentation Understanding Interest Rates Inflation and Bonds Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia Understanding Interest Rates Inflation and Bonds which you can find online. Take a look at the references. Resources continue your research from there. This by Barry Nelson updated March 17, 2022. In prior presentations, we've been taking a look at investment goals, investment strategies, investment tools, keeping them in mind. We're now considering understanding interest rates, inflation and bonds. Owning a bond is essentially like possessing a stream of future cash payments. So this is a common type of tactic when we're trying to be comparing different types of investments. We can think of them as a stream of future payments. Bonds lend themselves quite well to this type of analysis because we have a fixed kind of return. So we can think about that return in terms of future cash flows for things like the interest payments, possibly semi-annually, and then the maturity of the bond where we get the face amount of the bond. We might then try to present value that using our present value calculations and use that to value different types of investments due to different comparisons between them. We can use a similar method with other kinds of investments as well, but with things like equities that gets much more complicated because the idea of what the cash flow streams in the future will be for equities is harder to determine because you don't have that kind of fixed rate that's basically laid down at the front of something like a bond. So those cash payments are usually made in the form of periodic interest payments and the return of principal when the bond matures. So in the absence of credit risk, the risk of default. So note it's not quite as easy of course as just figuring out what the present value of future interest payments will be. For example, if we were to compare one bond, one investment to another because we also have to take into consideration risk. And with bonds you've got the risk that the person issuing the bond defaults doesn't pay the interest and so on. Some people less risky than others such as government bonds. So the value of that stream of future cash payments is a function of the required return based on your inflation expectation. So this article breaks down bond pricing defines the term bond yield and demonstrates how inflation expectations and interest rates determine the value of a bond. Measures of risk. There are two primary risks that must be assessed when investing in bonds. Interest rate risk and credit risk. Though our focus is on how interest rates affect bond pricing, otherwise known as interest rate risk. A bond investor must also be aware of credit risk. So interest rate risk is the risk of changes in the bond's price due to changes in prevailing interest rates. So we have changes. You can think of the interplay between like market rates and the rate basically on the bond. When you're investing say in a bond, you're kind of fixing the interest rate that you're getting a return because you're having a fixed return type of investment, which can be good. But then when you think about the market rates, if the market rates are going up in relation to the rate that we've locked in then if we have the money, we can basically invest in other types of investments at that point, possibly getting a higher rate of return. If market rates in essence go down and we've locked in our rate of return, then that could be a good scenario. So changes in short term versus long term interest rates can affect various bonds in different ways, which we'll discuss below. Credit risk meanwhile is the risk that the issuer of the bond will not make scheduled interest or principal payments. So hopefully when we're comparing bonds, we're comparing bonds that basically oftentimes people are comparing bonds that have high credit worthy people that they would be purchasing the bonds from such as government bonds or large corporate bonds for example. But if you had junk bonds for example or even a large company could go bankrupt or something like that and default basically on the payments for the bond, which is more risk there, government bonds typically being less risky in that sense. So the probability of a negative credit event or default affected bonds price, the higher the risk of a negative credit event occurring, the higher the interest rate investors will demand in exchange for assuming that risk. So clearly smaller companies typically will have to be paying higher rates in order to accompany or account for the fact that they're more likely to go bankrupt than a large company or the government. So bonds issued by the U.S. Department of the Treasury to fund the operations of the United States government are known as U.S. Treasury bonds, depending on the time until maturity. They are called bills, notes or bonds. We talked about them in the past. Investors consider U.S. Treasury bonds to be free of default risk. Again, that seems overly optimistic to me, but the idea would be that the fact, because I think there's risk involved in anything, but the idea would be the fact that if the United States government defaulted on their bond risk, that would be a very catastrophic situation because they have the power to tax and in essence print money. So you would think if they're defaulting, we'd be in trouble. So that's very low risk in that event because that shouldn't happen. In other words, investors believe that there is no chance that the U.S. government will default on interest and principal payments on the bonds at issues. Again, I would never say like zero, but it's as close to zero that we can basically get when we're investing in bonds. For the remainder of this article, we will use U.S. Treasury bonds in our examples, thereby eliminating credit risk from the discussion. So we're trying to say we're not going to be focused on the credit risk, but rather on the inflation risk. So it's calculating a bond's yield and price to understand how interest rates affect a bond's price. You must understand the concept of yield. So while there are several different types of yield calculations, for the purpose of this article, we will use the yield to maturity, the YTM calculation. A bond's YTM yield to maturity is simply the discount rate that can be used to make the present value of all the bond's cash flows equal to its price. So now we're going to think about the bonds as a stream of future cash flows and try to use present value calculations to help us out with our comparisons. So in other words, a bond's price is the sum of the present value of each cash flow wherein the present value of each cash flow is calculated using the same discount factor. So we can think about what is going to be the cash flows in the future. So if you've got like semi-annual payments, you can say into the future for however many years, 10 years or whatever, plus the maturity at the end. We can think about those cash flows, try to use our discounting features to basically bring them to like a present value kind of calculation to help determine what is the current value of those future cash flows. So this discount factor is the yield and so we're thinking about the yield being that rate that we would present value those future cash streams at which would make that stream of payment basically zero. That's going to be the yield. Or we can think about it as the rate that would be necessary to discount all future payments. That would be the stream of payments for all the interest payments and then the end payment at maturity for the face amount to be equal to the price. That would give us the YTM. So when a bond yield rises by definition, its price falls and when a bond yield falls by definition, its price rises. So these are the tools that we're going to use basically to value the price of the bond. So a bond's a relative yield. The maturity or term of a bond largely affects its yield. To understand this statement, you must understand what is known as the yield curve. The yield curve represents the YTM of a class of bonds, in this case US Treasury bonds. So in most interest rates environments, the longer the term to maturity, the higher the yield will be. This makes intuitive sense because the longer the period of time before cash flow is received, the greater the chance is that the required discount rate or yield will move higher. Inflation expectations determine the investor's yield requirement. Inflation is a bond's worst enemy. So obviously inflation is kind of going to increase basically kind of like market rates. So if you've locked in the rate to a bond and you have like a long term rate on the bond for that fixed income as interest goes up, then if you had the money, then you might be able to invest in similar kind of bonds now at the higher rate. So the fact that you're locked in could be bad for bonds that you've already purchased. So inflation arose the purchasing power of a bond's future cash flows. Typically, bonds are fixed rate investments. So that means you're going to have a fixed kind of return on them that's already determined, which can be great. But again, if that fixed rate starts to look bad or lower than the current market rate due to something like inflation, then that's when it doesn't play out to your advantage. If the market rates go down, for example, then it could be good. So if inflation is increasing or rising prices, the return on a bonds reduce in real terms, meaning your real earnings are now lower, given the fact that this purchasing power inflation is taking place, meaning adjusted for inflation. For example, if a bond pays 4% yield and inflation is 3%, the bonds real rate of return is 1%. So you're getting a 3% return. So that's great. So you're getting a return. But really, if the purchasing power of the dollar is going down, so inflation is going up by the 4%, then really, in real terms, you're actually losing money. You're losing purchasing power by the 1%. Again, that might not be terrible compared to the fact that if you compare it to other, when you diversify your portfolio and compare it to stocks, the stocks could straight go down in value if there were a recession. You can lose a lot on the stocks if there's kind of a downturn. So oftentimes you're using bonds as maybe a hedge against the stocks, which could go down dramatically. So in other words, the higher the current rate of inflation, the higher the expected future rates of inflation, the higher the yield will rise across the yield curve as investors will demand a higher yield to compensate for inflation risk. So note that Treasury-inflated protected securities, those are the tips, can be an effective way to offset inflation risk while providing a real rate of return guaranteed by the U.S. government. So we talked about tips a bit because they're supposed to move along with the inflation. So have some adjustments instead of being completely fixed. So as a result, tips can be used to help battle inflation within an investment portfolio. Short-term, long-term interest rates and inflation expectation. Inflation and expectations of future inflation are a function of the dynamics between short-term and long-term interest rates worldwide. Short-term interest rates are administered by nations' central banks. So here, of course, the central banks playing a factor. So anytime you're watching the news on the economy, you're hearing about the central banks a lot. In the United States, the Federal Reserve's Federal Open Market Committee, the FOMC, sets the federal funds rate. Historically, other dollar-denominated short-term interest rates such as the LIBOR, LIBOR or LIBID, LIBID have been highly correlated to the Fed's funds rate, giving the Fed a lot of kind of control or authority in that case. So the FOMC administers the Fed's fund rate to fulfill its dual mandate of promoting economic growth while maintaining price stability. So note that that mandate used to be just basically price stability, meaning don't let inflation get out of control, don't get in a situation of deflation. They then added the dual mandate, the two main things now, which is the other one is being employment. Now note that a lot of times from an economic standpoint, those two things are going kind of in opposite directions. In other words, when you're trying to fix things on terms of the price stability, oftentimes you've got to have short-term pain for the unemployment. So it's kind of an interesting play now because that ties the hands of the Fed in some ways to take care of the one and only original mandate was like, don't get inflation out of control and don't see deflation. So this is not an easy task for the FOMC. There is always debate about the appropriate Fed funds level and the market forms its own opinions on how well the FOMC is doing, of course. You can hear endless debate about it. Central banks do not control long-term interest rates. Market forces supply and demand determine equilibrium pricing for long-term bonds which set long-term interest rates. If the bond market believes that the FOMC has set the Fed funds rate too low, expectations of future inflation increase, which means long-term interest rates increase relative to short-term interest rates, the yield curve steepens. If the market believes that the FOMC has set the Fed funds rate too high, the opposite happens and long-term interest rates decrease relative to short-term interest rates, the yield curve flattens. So the time of bonds cash flow and interest rates, the timing of a bonds cash flow is important. So this includes the bonds term to maturity, meaning how long until the bond matures at the end. So remember, you can think of the bonds as kind of two different cash flows. You're making the initial investment upfront, but then on the return side of things, you typically have a stream of cash flows that's going to be fixed possibly semi-annually, and then at the termination or end of the bond, you should receive basically the face amount of the bond. So if market participants believe that there is higher inflation on the horizon, interest rate and bond yield will rise and prices will decrease to compensate for the loss of the purchasing power of future cash flows. Bonds with the longest cash flow will see their yields rise and prices fall the most. So this should be intuitive if you think about the present value calculation when you change the discount rate used on a stream of future cash flows the longer until cash flow is received, the more its present value is affected. So in other words, if you're thinking that there's going to be interest rates rising into the future and you're looking at these bonds that are going to mature into the future, remember there's a stream of payments. We might do some calculations on this in future presentations to kind of isolate this down a bit more, but the idea being you've got a stream of payments that you're going to be receiving and then you've got that lump sum, which is the face amount that you receive at the end. Now if you're going to get that further out into the future and you think that there's going to be inflation by the time you get that last payment then it's going to be worth less in terms of purchasing power if you think you're in a period of inflation and so therefore you would think the value of the bond would be less than. So that would be decreasing or deteriorating the value of the bond as you consider the inflation going up and the longer term bonds that have that lump sum face amount payment at the end would be the ones that would be more thoroughly or heavily affected. So the bond market has a major of price change relative to interest rate changes. This important bond metric is known as duration. So what's the bottom line? Interest rates bond yield prices and inflation expectations correlate with one another. Movements in the short term interest rates as dictated by the nation's central bank will affect different bonds with different terms to maturity differently. So obviously all the factors within the bond in terms of how long until maturity will be different surely affected with changes to the short term rates depending on the market's expectations of future levels of inflation. So when we're thinking about the prices of the bond people are always doing the speculation trying to figure out what's going to happen in the future with regards to inflation which will have an impact on what they believe the value of the bonds will be. So for example a change in short term interest rates that do not affect long term interest rates will have little effect on long term bonds price and yield. However a change or no change when the market perceives that one is needed in short term interest rates that affect long term interest rates can greatly affect a long term bonds price and yield. So put simply changes in short term interest rates have more of an effect on short term bonds than long term bonds and changes in long term interest rates have an effect on long term bonds but not on short term bonds. The key to understand how a change in interest rates will affect a certain bonds price and yield is to recognize where on the yield curve that bond lies the short end or the long end and to understand the dynamics between short and long term interest rates. So with this knowledge you can use different measures of duration and convexity to become a seasoned bond market investor. So we might dive in to some more of those concepts in the future using some calculations but here's just basically an overview of some of these concepts so you can get a general feel of how these kind of market forces are working how you can basically value the bonds, how you can think about the bonds as a stream of basically cash flows and use discounting present value factors, time value of money factors to help to value bonds and set prices of the bonds. Again we might dive into the calculations on that in future presentations.