Today is Fed rate day. This afternoon Federal Reserve Chairman Kevin Warsh announced a unanimous decision to increase the Fed funds rate by 0.25%. Today we’re going look deeper into the bond market functioning and not focus on the Fed.
But the real question is whether the Fed leads the market, or whether the market has in fact determined interest rates independently of any committee decision. Was the Fed announcement merely a reflection of what the market has already been saying for weeks?
You see bond yields are determined by the laws of supply and demand, combined with a risk premium layered on top of the coupon rate.
The simplest explanation for bond yield and discounting the bond price is to ask each of you listening to this podcast for your own personal decision when presented with a bond offer.
Let’s imaging for a moment that the coupon rate on a 10 year bond is 5%. That is the rate to maturity. But now let’s say that inflation is running at zero percent per year. That 5% face value on the bond is real income that is coming to you each and every year for that 10 year period. At the end of 10 years you get the final year of interest along with the full face value of the bond. That’s the ideal scenario that every investor would want.
But now let’s imaging a different scenario. Let’s imagine that inflation is running at 4% and the bond has a face value of 5%. The simple math says that your yield is only 1% above the face value of the bond. So while the bond says 5%, the currency is being devalued by 4% leaving a difference of 1%. That might not be so attractive. So instead, you decide you’re going to offer to buy the bond at a discount in order to compensate for the fact that the bond is only giving you a yield that is 1% above inflation.
You will notice that the Fed’s opinion of interest rates didn’t come into the conversation for your personal investment. You are merely making a decision about what rate you want the bond to yield in order to meet your investment criteria.
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