The bond-pricing equation from our last article is a rather superficial explanation of how bond prices fluctuate. It cannot be emphasized enough that bonds are like stocks in that their prices are never static - they constantly shift all day. What’s interesting, however, is that many of the other factors which influence bond prices technically influence bond coupon rates (which in turn influence the final prices). But without further ado, we’re going to look at the relationship between inflation, ratings, and bond prices.
Now unlike inflation, we did go over how bonds are affected by interest rates: higher interest rate means more money which means higher price. If the government lowers interest rates for their bonds, this increases the prices for private bonds since they now offer more money. Here, however, is where some hairs must be split. A bond's coupon rate is the annual percentage that must be paid back to whoever owns the bond. So say I sell you a $100 bond with a 10% coupon rate, this means you must pay me $10 every year until maturity (when the loan is to be paid back in full). A bond’s yield or interest rate, on the other hand, is affected by the coupon rate as well as the bond price itself.
So that $100 bond I sold to you, say I sell it in the secondary market, where previously issued financial instruments are bought and sold, at a discount for $80. The coupon stays the same, meaning whoever now owns the bond still receives $10 per year. But because my buyer is purchasing the bond for $80, the yield goes from 10% (what it originally was with me selling it at $100) to 12.5% ($10/$80).
A similar thing occurs if I sell the bond at a higher price, say $150: the coupon stays at $10 per year, but the yield is now 6.6% ($10/$150). In other words, bond price and yield move inversely. Think of this relationship as a seesaw, with one end going down only if the other end goes up and vice versa. But the question then becomes what moves the seesaw? It’s a combination of really 3 things:
1. Coupon and interest rates: (see above) both that of the bond in question as well as that of competing bonds.
2. Inflation: a general rise in prices in fact tends to lower bond prices ironically enough. How can this be the case? This is because rising prices decrease money’s purchasing power, including that which is received through bond interest payments. So once more turning back to our 10-year $100 bond with a 10% coupon, say the inflation rate is and will continue to be 5% for the next decade. This means that the nominal, inflation-adjusted bond interest rate is 9.5% (the bond yield, $10, minus 5% of it is $9.5, which is 9.5% of $100).
This particular situation isn’t all bad, since the bond owner would still enjoy healthy returns, but it’s now going to be worth slightly less than $100 since the yield has decreased. If the bond owner still wants a 10% yield, he should buy the bond at $95 (9.5% * 10 years = $95).
3. Bond ratings: these are grades given to bonds that indicate their credit quality which range from “AAA” (maximum safety, best quality bonds out there) to “D” (as in default, meaning payments have not been made on the due date). The purpose of these ratings is straightforward: for potential investors to have a quick glance as to what kind of risk they’re dealing with. It goes without saying that the higher-rated bonds offer lower returns and coupon rates, whereas the lower-rated bonds offer higher returns and coupon rates. The three main rating agencies in the US are Moody’s, Standard and Poor’s, and Fitch.
Bonds are a curious sort of investment vehicle. In a situation where someone is lending another person money, we’d initially expect only those 2 people to really be involved in this sort of transaction. But bonds, which do the lending part, behave in the opposite manner - the parties directly involved constantly shift with each bond sale, which partly explains their popularity among investors: if they don’t like it, they can simply find someone else who’s willing to take on the burden.
Econ IRL
Could welfare programs impact someone not only materially, but also on a neurological level? The answer is a resounding yes according to this week’s paper. Researchers recruited 1000 low-income mothers who recently gave birth to healthy newborns and randomized half of them into a nominal cash gift group where they received $20 per month, with the other half being put into a large cash gift group where they received $333 per month.
The results? The kids in the latter group showed greater mid-to-high frequency power (which consists of alpha, beta, and gamma brain waves) and decreased low-frequency power (which consists of theta brain waves) than those in the former group. Lower theta waves typically means lower levels of anxiety and poor emotional awareness, whereas higher alpha, beta, and gamma waves are responsible for coordinating communication, cognitive reasoning, reading, calculation and memory processing. What this all suggests is that poverty intervention programs change children’s brains in ways that are linked to subsequent higher cognitive ability.