Bond markets, Interest rates and Inflation

Bond prices are determined by the coupon payments earned on the bond (for bonds that earn coupon), and the present value of the face value of the bond. In calculating the value of a bond, the YTM (yield to maturity) is used to discount the future cash payments of a bond to its present value. The YTM is the rate that equates the price of the bond to its future payoff. One can also think of the bond's yield as the rate that bondholders require to receive to compensate them for the risk associated with holding the bond. Buying a bond is similar to a bank lending money to a customer. During the term of the loan's life the borrower makes payments that cover both interest (which is essentially the cost of borrowing) and the principal borrowed. The YTM of a bond is in a way determined by the risk factors surrounding the bond issue and issuer such as default risk, interest rate risk, reinvestment risk and so on. The YTM has an inverse relationship with the price of the bond so when it falls, bond price rises and people switch over to the next best thing, stocks. Also, the longer the term of the bond, the higher the YTM because the greater the riskiness of the bond.

Short term interest rates are set by the central bank by controlling the overnight rate (the rate at which banks lend to each other). When short term interest rate is perceived to be too low, people expect inflation to rise in the future- since low interest rate encourages borrowing and spending which lead to higher inflation, and long term interest rates which is determined by the demand and supply of funds increases. When investors expect inflation to rise, they demand higher yield on their bond holdings (and bond price falls). Investors need to be compensated for higher expected inflation because inflation erodes the purchasing power of the payments they will receive in the future. This unfavourable relationship can be seen when real return is compared to nominal return (which is accentuated by inflation). If for example, a 5 year bond in a developing country quotes a yield of about 10% but inflation is 5%, the real return earned is only 5%.

To recap and summarize: Interest rates are determined by the central bank in the short run and by market forces in the long run. When short term interest rates are perceived to be too low inflation is expected to rise and bond yield increases to compensate bond holders for higher inflation leading to a fall in the price of the bond.