Bonds and the Economy
Economic trends are one of the key drivers of the bond market’s performance, but the economy affects different types of bonds in various ways depending on each bond's exposure to interest rate risk.
Interest rate risk essentially means that bond owners will have their returns affected to varying degrees based on the amount of fluctuation experienced in interest rates. The amount of risk added to a bond through interest rate changes depends on how much time until the bond matures, and the bond's coupon rate, or annual interest payment.
How Economic Growth Impacts U.S. Treasuries
Bonds issued by the U.S. Treasury are typically the ones most directly impacted by the economy. The best way to understand the relationship between the economy and bonds is to think about interest rates as being the cost of money.
When the economy is strong, the demand for money is higher, since greater spending activity means that there is more of a need for cash to finance projects. Higher demand, in turn, drives up costs, and in this case, interest rates.
In addition, stronger economic growth makes inflation more likely, at least in theory. In this type of environment, the U.S. Federal Reserve (“the Fed”) is likely to boost interest rates to slow down the economy a bit in an effort to fight inflation. When short-term interest rates are expected to go up, longer-term interest rates typically follow.
The result for Treasuries is that stronger growth typically results in higher yields, along with lower prices since prices and yields move in opposite directions.
On the other hand, slower economic growth reduces the demand for money, since individuals and businesses are less likely to take out loans to finance projects and purchases. Lower demand for loans means prices, and in this case, interest rates, fall as well.
In this scenario, weaker growth means the Fed is more likely to reduce short-term interest rates to encourage people to borrow and spend, which supports the economy. As a result, longer-term Treasury yields typically move the opposite direction and fall when economic growth is expected to weaken.
How Growth Trends Affect Other Bond Market Segments
All areas of the bond market ultimately take their cue from Treasuries, since, correctly or otherwise, U.S. government bonds are seen as being the safest investment in the world and therefore set the baseline for the rest of the market. Certain types of bonds, other than Treasuries, tend to benefit from stronger growth, rather than being hurt by it.
First, the yields on these bonds are high enough that modest moves in Treasury yields have less of an impact on their performance. For example, if the 10-year Treasury is yielding 2.0 percent, a mortgage-backed security with a yield of 2.5 percent (a 0.5 percentage-point gap) is affected to a greater extent than a below-investment-grade corporate bond yielding 8.5 percent (a 6.5 percentage-point gap).
Second, the bonds of corporations and emerging markets trade based on their credit ratings, which are driven by their underlying financial strength. The better these companies' balance sheets, cash balances, and underlying business trends, the less likely they are to default on their bonds (i.e., miss a payment of principal or interest). The lower the likelihood or risk of a bond default, the lower the yield investors are able to demand as compensation for them taking on the risk of investing in that particular security.
As a result, while stronger economic growth can be a negative for Treasuries, it is much more likely to be a positive factor for higher-yielding bonds where the issuer’s creditworthiness is a primary concern for investors. This helps make the case for why investors should diversify rather than concentrate their holdings in any one segment of the bond market.
Inflation's Effects on Bonds
In an inflationary environment, bonds suffer because their future cash flows will have less value than the same cash received today. The higher inflation, whether today or in the future, the more risk investors take by tying up their money in bonds. This causes investors to demand a higher interest rate, or yield, to compensate them for this additional risk.