Effect of a rise in interest rate on bond yields?

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rodra333

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Can someone explain the reason behind why if the FED rises the rate of interest bond yields would increase?
 
“3.1.3.2 Fixed-Income Premiums The expected bond return, E(Rb), can be built up as the real rate of interest plus a set of premiums:
E(Rb) = Real risk-free interest rate + Inflation premium + Default risk premium + Illiquidity premium + Maturity premium + Tax premium”

The Fed Rate = Real Risk-free interest rate.
 
And why a rise of interest will increase the bond yields?
As I see it, a wide on the bond yield means higher risk.
The connection as I see it is that if interest rate increase the cost of money is higher –> higher exposure to defaults –> bond yield rises.
Please correct if Im wrong.
 
the way I see it - the first piece Real Risk Free Rate increases.
So the Yield on the bond itself increases - all else equal.
So a rise in the base rate - will in general cause all bond rates to rise.
The other factors is for comparison between bonds of differing characteristics.
A B-Rated bond would have a higher rate than a BBB Bond - because Default Rate on a BBB bond is less than the default rate on a B-rated bond.
There is a EOC problem on the Fixed Inc chapter - which highlights this point to you. (check out Q3).
 
rodra333 wrote:
Can someone explain the reason behind why if the FED rises the rate of interest bond yields would increase?
Click to expand...
Another way to recognize this is that bond prices and bond yields are inversely related. When rates moves one way the price moves the other.
Also remember that bonds will “price” off of the yield of some benchmark bond, usually a treasury bond.
For example, say that Boeing has a bond that matures in 10 years. It is currently trading at a spread relative to the 10-year US Treasury bond. So if the 10yr UST is yielding 2%, the 10yr BA bond will probably trade at a yield of 2.8% or “T+80”. This is the way corporate bonds are priced when they are issued.
The Fed “raising rates” will also affect long-term rates and will likely push up the interest rates across the curve. So all of a sudden the 10yr UST is now yielding 2.2%. The market will appropriately price that into the 10yr BA bond and it will probably maintain a very similar spread of 80 basis point to the UST and it will now yield 3.00%. Remember that yields and price are inversely related. The actual coupon that is clipped every 6 months is not suddenly greater (i.e.e the “interest rate” of the bond is unchanged), but the price of the bond will trade lower so that the yield of the bond until maturity is now higher at 3.00%.
 
i think there is no rule in the text that says it is so. I’m sure if the fed set short rates to 5% tomorrow then 30yr rates could drop & you would see a massive inverted curve.
stick with the cfai and avoid reading outside the curriculum.
 
Thanks a lot everyone! Great examples!!
I see it a lot clearly now.
 
onlysimon wrote:
i think there is no rule in the text that says it is so. I’m sure if the fed set short rates to 5% tomorrow then 30yr rates could drop & you would see a massive inverted curve.
stick with the cfai and avoid reading outside the curriculum.
Click to expand...
I think only exceptionally, due to term premium and inflation compensation.
 
15g (page 49 book 3) talks about deflation and bond prices. I really think this is very testable stuff and shouldn’t be considered away in the clouds.
a rate hike plus weak growth equals deflationary expectations. plus expectations of corporate defaults then gov bond yields will surely drop.
 
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