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In finance, bonds are instruments of indebtedness of an issuer to the holders, under which the issuer owes the holders a debt and an interest (the coupon) or to repay the principal at a later date (maturity date).
In other words, a bond is a form of loan where two entities act: the creditor that is the holder of the bond and the issuer of the bond that is the debtor. They are used by the issuer in order to gather external funds to finance long-term investments, or in the case of government bonds, to finance current expenditure.
Bonds are commonly issued by governments at all levels and corporations and are typically not secured by collateral. They are more frequently traded than loans, and moreover, they can be held by retail investors while loans can’t. Also, generally, they are sold in relatively small denominations of around $1,000 to $10,000.
The Bond Market is a financial market that has as a primary goal to provide long-term funding for public and private expenditures, allowing participants to issue new debt on the primary market, or buy and sell securities on the secondary market.
Government bonds are an important component of the bond market, in fact, government bonds are often used to compare other bonds and also to measure credit risk, because the yield on government bonds in low-risk countries such as Germany or the United States is considered a risk-free rate of default.
Supply, Demand and Market Equilibrium
To understand in-depth how the prices of bonds are determined is important to look at how the forces of supply and demand behave in the bond market.
The Demand Curve
In order to make our analysis easier to understand let’s consider the demand for a bond with a one-year maturity, that makes no coupon payments but that pays the owner at maturity the $10,000 face value. In this case, given that the holding time is one year, the return on this bond is equal to the interest rate as measured by the yield to maturity, which is obtainable from the following equation:
i (yield to maturity)= F (face value) – P (initial purchase price) / P
Assuming that the bond sells for $9,750, the expected return (interest rate) is 2,5%. At this interest rate level, we can assume that the total quantity demanded is $100 billion (point A). Then, at a price of $9,000, because the expected return is higher (11,1%), suppose that the quantity demanded is $200 billion (point B).
Then, as you see in the following graph, we have plotted the demand curve following the assumption shown before, which shows that a lower price the expected return is higher (everything else being equal), and therefore the quantity demanded will be higher.
The Supply Curve
The supply curve shows the relationship between the quantity supplied and the price of the bond when other economic variables are held constant, it describes the behavior of suppliers that in this case are borrowers (companies, and governments) that issue bonds in order to finance their activity.
The supply curve for this example is based on the same assumption that every variable besides the price of the bond and interest rate are held constant, and therefore when price increases the expected return (interest rate) goes down, which makes it less costly to borrow by issuing bonds, therefore supply goes up.
In economics, market equilibrium refers to a situation where the supply curve and the demand curve meet, that is the price where the amount that individuals are willing to buy (demand) equals the amount that individuals are willing to sell (supply).
In our example, the market equilibrium is where the quantity of bonds demanded equals the quantity of bonds supplied, which is point E, where demand and supply meet.
In fact, for example in point A there is excess supply because at that interest rate borrowers are more likely to issue more bonds because it is cheap, they have to pay low interest to lenders, and on the other hand lenders think that they can obtain better returns elsewhere, therefore they will demand fewer bonds. This means that prices will go down, towards the market equilibrium, where suppliers prefer to issue fewer bonds and lenders are willing to buy more bonds because they can get a return that is more interesting than before.
On the other hand, in point C, where demand is excessive with respect to supply because returns are very high, the price will go up, leading to an increase in supply and a tightening in demand, towards the market equilibrium.
This mechanism might take some time but it is important to understand how it works because in the bond market, and in markets in general because in the long term prices tend to head toward market equilibrium.
How changes in equilibrium interest rates affect prices
In the following section, we will analyze why equilibrium interest rate changes by using the supply and demand framework for bonds introduced before.
A change in the equilibrium interest rate is caused by a shift in the demand (or supply) curve, which can be caused by changes in some factors other than the interest rate and bond price. The demand (or supply) curve shifts only when the quantity demanded (or supplied) changes at each given price (or interest rate) of the bond, therefore it is a different mechanism with respect to the one that causes movements along the demand (or supply) curve, that usually happens as a result of a change in the price of the bond, and therefore causes the quantity demanded (or supplied) to move from one point to another along the same curve.
Shifts in Demand
In order to understand what makes the demand for bonds to shift it is useful to look at portfolio theory, which tells us how much of an asset people will want to hold in their portfolios, and it states that it is influenced by four main factors:
- Wealth: if wealth in an economy increases, due for example to a growing economy, the quantity of bonds demanded at each price or interest rate increases. This means that when the business cycle is expanding and therefore income and wealth grow, the demand curve for bonds shifts to the right. On the other hand, in a recession, given that wealth and income are lower, the demand for bonds falls as well, and the demand curve shifts to the left;
- Expected returns can cause the demand curve to shift because, when talking about long-term bonds, if markets expect lower interest rates and therefore higher future returns, demand will inevitably increase, and therefore the demand curve will shift to the right. On the contrary, if people expect higher interest rates and therefore lower returns in the future, demand will go down and the demand curve will shift to the left. With expected returns, it is also important to take into consideration the influence that the expected returns of alternative assets, like stocks, can have on the demand for bonds. In fact, an increase in the expected return on alternative assets makes the demand curve shift to the left as a result of lower demand for bonds. Finally, expected inflation is another factor that can make the demand for bonds to shift, in fact, if the expected rate of inflation increases, returns on bonds will inevitably be lower, causing, therefore, a decline in demand for bonds and the demand curve to shift to the left;
- Risk usually makes bonds less attractive, therefore if the level of risk increases, the demand for bonds will tend to fall, making the demand curve to shift to the left, while an increase in the riskiness of other alternative assets makes bonds more attractive, therefore demand for bonds rise and the demand curve shifts to the right;
- Liquidity is an attribute that makes assets, in general, more attractive, therefore if the liquidity of bonds increases, demand will rise too, and the demand curve will shift to the right. At the same time, like what happens with risk and expected returns, the liquidity of other assets can affect the demand for bonds, in fact, if other assets become more liquid, the demand for bonds will go down and the demand curve will shift to the left.
Shifts in Supply
As in the case of demand, the supply curve for bonds can shift too, and it is a result of changes in the following factors:
- Expected profitability, which relates to the expectations that firms have about investment opportunities, in fact, when opportunities for profitable plant and equipment investments are plentiful, which usually happens when the business cycle is expanding, firms are more willing to borrow in order to finance their projects. Therefore, the supply of bonds increases, and the supply curve shifts to the right. On the other hand, when the economic outlook is bad and firms can’t find good opportunities, the supply of bonds falls and the supply curve shifts to the left;
- Expected inflation in the case of supply has the opposite effect that it has on the demand. In fact, given that when inflation increases, the real cost of borrowing falls, making borrowing cheaper. Therefore, we can say that an increase in expected inflation causes the supply of bonds to increase and therefore the supply curve for bonds to shift to the right.
- Government budget deficit, the activities of the government have a major impact on the supply of bonds, mainly because when the government decides to spend more than it earns, therefore expanding its budget deficit, it has to increase the supply of bonds in order to finance this excessive spending, making, therefore, the supply curve to shift to the right. On the other hand, a government surplus, which consists of earnings higher than total expenses, leads to a decrease in the supply of bonds, and therefore the supply curve shifts to the left.