Hi Everyone, Like to invite your discussions and ideas about the confusing concept of the impacts of economic factors on fixed-income (Bond) market. On the fixed-income (bond) market, capital gains and income yield are directly conflicting and moving in the opposite directions. Say, bond value decrease indicates a higher yield looking forward and the opposite works well. Now assuming the economy is growing, in this scenario, there are also few relevant economic factors like potential increasing inflation expectation and higher short-term interest rate by central bank. My question is the impact and effect on bond (fixed income security) market. Increasing economy gives increasing pressure on required yield to bond, also the increasing expected inflation and interest rate all give pressures to bond value to decrease, and yield to increase. This can be interpreted as a negative impact on bond market but only to the investors who are now inside the market and holding bonds on hand. For an investor who is holding cash and waiting and ready to enter the bond market, he may see this is a positive sign and happy to buy cheaper bonds with higher forward yield. So this always confuses me, how to interpret the “positive” or “negative” depends on the investor’s standing point, inside the bond market or ready to enter. What’s CFA’s standard/classic explanations? Thanks, JXYZCFA
Timing is always paramount in investing. During “good” times, bond yields rise (sometimes substantially) as cash flows out of bonds and into equities or other more promising asset classes. Conversely, during depressed economic environments, investors flock over to bonds thereby depressing yields. So is it good or bad when bond yields rise/fall? Depends on who’s holding the bag. The same can be true for equities too however. If you bought at the peak in 2007, you lost a good chunk when the market tanked. In making any investment decision, you must evaluate the timing and valuations at the time. Buy low and sell high right?
When talking about investment “Timing”, you have already put yourself on the position of an outsider or potential investor (holding cash and waiting to invest) instead of an existing investor who is in the market already holding the securities. So the viewpoint of a potential outside investor could be different. And with regard to Equity, it is also different than bond in that the capital gains are not necessarily conflicting with dividend yield. The investor can enjoy constant or steadily increasing dividend income together with stock price appreciation. In this ideal situation, investors who are either holding cash ready to invest in equity or holding stock on hand would share a similar happiness (positive view to the equity market). But in Fixed-income, yield and bond value always go opposite directions. If focusing on yield side and admitting that high yield means positive, then you have to accept that low bond value = positive, which is somehow counter-intuitive.
Positive or negative impact should always be evaluated from the vantage point of where your assets reside. In the example you describe (economy heating up, holding cash), the environment is becomming less attractive for cash investors. Once you move into bonds, you effectively lock in your rate of return based on the price you paid (ignoring floaters for a moment). Once you enter, if rates move up or down, it doesn’t change your rate of return. It does, however, change your ability to exit the market at a profit. So, from the bond investor’s perspective, if rates move up, that is a negative because it means that the price of the bonds s/he holds is going down (and vice versa).
You explained the aswers yourself…when you call someone a bond investor, it mean that he has a vested interest in the market and hold a portion in the portfolio. Though higher yield may look juicy for someone who wish to enter the market now, however here we are talking about the “so called investors” who will lose their value and are negatively impacted by higher yields in the market…So the CFAI standard answer would be investors will lose money…forget about potential investors when answering such questions, unless specifically asked. don’t assume that higher yield provide an opportunity, who knows higher yield may not be high enough, as we experienced in the current financial meltdown.
Naturally if passage says something about potential investors you’ll need to factor that into your answer, but think of bond prices just as you’d think of stock prices. When the Dow rallies it’s seen as good for equities, when bond prices go up it’s seen as a positive for bonds.
Brent Favre Wrote: ------------------------------------------------------- > Positive or negative impact should always be > evaluated from the vantage point of where your > assets reside. In the example you describe > (economy heating up, holding cash), the > environment is becomming less attractive for cash > investors. Once you move into bonds, you > effectively lock in your rate of return based on > the price you paid (ignoring floaters for a > moment). Once you enter, if rates move up or down, > it doesn’t change your rate of return. It does, > however, change your ability to exit the market at > a profit. So, from the bond investor’s > perspective, if rates move up, that is a negative > because it means that the price of the bonds s/he > holds is going down (and vice versa). There is no guaranteed rate of return in bonds. Re-investment risk is real and it has a higher impact the longer the holding period. Not all bonds investors hold to maturity though and if you are caught in a liquidity crises while rates are up… hmm.