How Are Bond Yields Affected by Monetary Policy?

Bond yields are significantly affected by monetary policy. These policies may come from the actions of a central bank, such as the Federal Reserve, a currency board, or other types of regulatory committees.

Monetary policy at its core is about determining interest rates. In turn, interest rates define the risk-free rate of return. The risk-free rate of return has a large impact on the demand for all types of financial securities, including bonds.

Some Bond Basics

Basically, a bond yield is the return an investor realizes on that bond. There are several types of bond yields, but one of the simplest—and most relevant to this discussion—is the current yield, a function of the bond's market price and its coupon or interest payments. (After they are issued, bonds trade on exchanges, like other securities, their prices rising and falling with supply and demand.)

Current yield is derived by dividing the annual coupon payments—that is, the interest the bond is paying—by its price. The formula for the current yield is:

This is first cardinal rule to remember about bonds: As bond prices increase, bond yields fall. Let's say you have a $1,000 bond that has an annual coupon payment of $100, and it's selling near par, for $1,010. Its yield is 9.9% ($100 / 1010). Now, let's say the bond's price jumps to $1,210. Its yield falls to 8.3% (100 / 1210).

Interest Rates and Bond Yields

So, what makes bond prices move? Several things, but a key one is prevailing interest rates. And this is the second cardinal rule to remember about bonds: When interest rates are low, bond prices increase—because investors are seeking a better return. Say the Federal Reserve slashes the federal funds rate (the interest it charges banks, on which other interest rates are based) from 3% to 1%.

If there's a bond trading on the market that's paying 4%, that's suddenly going to be a lot, and everyone's going to want it. So, in the time-honored tradition of supply and demand, its price will go up. And because you're paying more for it, its yield becomes less. The increased demand for the bond results in rising prices—and falling yields.

Of course, the inverse is true as well. When the risk-free rate of return (like what you find in U.S. Treasury bonds and bills) rises, money moves from financial assets to the safety of guaranteed returns. For example, if the interest rate rises from 2% to 4%, a bond yielding 5% would become less attractive. The extra yield would not be worth taking on the risk. Demand for the bond would decline, and the yield would rise until supply and demand reached a new equilibrium.

The Effect of Monetary Policy on Bond Yields

Interest rates are a key part of a nation's monetary policy. Monetary policy is shaped and set by a government administration, and executed through its central bank (in the U.S., that's the Federal Reserve). Central banks are aware of their ability to influence asset prices through monetary policy. They often use this power to moderate swings in the economy. During recessions, they look to hold off deflationary forces by lowering interest rates, leading to increases in asset prices.

Increasing asset prices have a mildly stimulating effect on the economy. When bond yields fall, it results in lower borrowing costs for corporations and the government, leading to increased spending. Mortgage rates may also decline with the demand for housing likely to increase as well.

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