In the volatile market conditions, investors tend to favor bond investments. According to the Hong Kong Investment Funds Association data, more than 60% of new funds in the first half of 2019 flowed into bond funds. More and more investors are also starting to directly engage in the bond market. However, there is no shortage of investors who know a little about bonds. Some investors want to invest in US government bonds to get more than 5% of the return, and some investors do not understand the difference between the coupon rate and the yield to maturity. In this issue, the author briefly introduces the most important factor affecting bond prices – interest rates.
Generally speaking, investors are most concerned about the benchmark interest rate. However, because different bonds have different maturities, the benchmark interest rate cannot fully explain the changes in bond prices. Although the benchmark interest rate has roughly reflected more than 80% of bond price movements, bond yields in different years will still have an impact. Investors need to combine the interest rates of different years, that is, the interest rate curve, to understand the factors affecting prices.
1.Short-term interest rate
Short-term interest rates can usually be measured by the 1-year bond yield. This rate of return is mainly affected by the central bank’s monetary policy. If the central bank decides to cut interest rates, bond yields will fall. Market supply and demand will affect short-term interest rate changes, but central banks can influence market interest rates to fluctuate within a set range through open market operations such as repo and reverse repo.
2.The direction of monetary policy in the coming year
Short-term interest rates are often synchronous indicators that reflect the interest rate environment at the time. The difference between the 12-month forward 1-year bond yield and the 1-year yield can reflect the direction of monetary policy in the coming year. If this indicator rises, it means that monetary policy may tighten in the coming year. On the contrary, the decline in the indicator reflects that the monetary policy will become loose in the coming year. In addition, because this indicator is affected by the market, it will also reflect the market’s risk appetite. If this indicator fluctuates sharply or is higher than the expected interest rate, reflecting the market’s concern that the outlook for monetary policy is unclear, it is necessary to pay a higher risk premium.
3.Economic and inflation prospects
In general, medium and long-term bond yields are mainly determined by inflation and the early economic period. The market generally reflects this factor with a five-year forward 5-year bond yield. If the yield of forward bonds rises, reflecting that the market believes that the future growth of the economy is higher than the current, the inflation outlook will also rise. The advantage of using this indicator is to rule out the impact of the current currency cycle on inflation and economic growth.
Investors’ liquidity, risk appetite, and even investor preferences for long and short periods can also affect the difference in bond curves. The market typically uses the difference in 30-year and 10-year bond yields to represent the client effect. If investors are more conservative, the gap between this indicator will widen. Funds need to provide more premiums to compensate for liquidity and risk appetite.