Bonds affect the economy, and the economy affects bonds. Here’s how they are related as well as how they impact each other.
How Economic Growth Works
Economic growth occurs when a country increases its rate of economic output, which is known as “gross domestic product” (GDP). GDP is the most commonly used measure of an economy’s performance. A positive change in GDP means economic growth; a negative change means shrinkage. When the economy grows, the demand for money rises. More money is demanded, because there are more products and services available. People can spend more, since the employment rate and wages often rise along with growth.
Interest Rate Risk
Interest rate risk means that bond returns vary based on the amount of fluctuation in interest rates. The amount of risk added to a bond through interest rate changes depends on a few factors: how much time until the bond matures, the bond’s coupon rate, or its annual interest payment. The longer you hold a bond, the more risk you accept. This risk only applies to investors who do not hold the bond to maturity. If you decide to sell the bond to a third party before maturity, then the fluctuation of interest rates matters. If interest rates have risen since you first bought the bond, then you will likely have to sell it for less than you paid for it in the first place. That’s because bond prices and interest rates are inversely related.
How Economic Growth Impacts Bonds
Higher currency demand causes inflation, which is the reduction of a currency’s purchasing power. In other words, an item worth $1 today might be worth less than $1 a week from now. To combat inflation, the Federal Reserve (the Fed) uses monetary policy tools. These include interest on required reserves, overnight reverse repurchasing, and the discount rate. These tools help influence the federal funds rate, which then impacts interest rates. Rising interest rates can make investors more interested in stocks because bonds sell for less. Slower economic growth reduces the demand for money. That’s because individuals and businesses are less likely to take out loans to finance projects and purchases. Lower demand for loans causes prices to fall and interest rates to rise. Bonds can then become more attractive than stocks because of their fixed yields.
Growth Trends and Other Bond Market Segments
U.S. Treasurys are considered benchmarks for bond performance. Thus, if you’re a bond investor, you may base some of your decisions on the returns of Treasurys. Some types of bonds other than Treasurys benefit from stronger economic growth rather than being hurt by it. These segments often include high-yield bonds, emerging markets bonds, and lower-rated corporate bonds. The yields on these bonds are high enough that modest fluctuations in Treasury yields have less of an impact. Corporate bonds and emerging markets trade based on their credit ratings, which are driven by their financial strength. The stronger their balance sheets, cash balances, and business trends, the less likely they are to default (miss a payment). The lower the chance of a bond default, the lower the yield you can expect. Investors require a higher yield when the chance of bond default is elevated, but they are willing to accept less if the chance of default is remote. A stronger economy lowers returns on Treasurys and bonds, but it is much more likely to be a positive factor for higher-yielding bonds where the issuer’s creditworthiness is a major concern. This difference helps make a case for diversification. It’s a wiser option than concentrating your holdings in any single segment of the bond market.
