Bond yields are closely followed by investors as these affect interest rates. In this article we discuss what the relationship is between bond yields and interest rates and how it affects the share market.

What are bonds?

A bond is a loan taken out by a company or a government when they want to raise money. Purchases of bonds are essentially giving the issuer a loan and the issuers agree to pay back the face value at a specific date. The buyer also receives regular interest payments through the life of the bond.

Predicting the Economy

Short term rates are set by central banks. They evaluate different economic indicators before setting this rate.

Long term interest rates are determined by the market.  The bond market will determine whether they think the central bank has acted appropriately given the current economic environment. If the bond market thinks the central banks have set the interest rates too low then there will be expectations of increased inflation. This will cause long term interest rates to increase to reward bond investors for the loss of purchasing power associated with the future cash flow. If bond investors think the central banks have set the interest too high, then long-term interest rates will decrease as there will be expectations of decreasing inflation.

A normal yield curve shows low yield for shorter maturity bonds and higher yields for longer maturity bonds.  There is greater probability that interest rates will rise with longer term bonds than shorter term bonds and hence yields become higher as maturity is longer. Interest rate rises negatively impact bond prices.

How does this affect the equity market?

When bond yields go up, the market is factoring in an interest rate rise.

Traders are very interested in the direction of interest rate movements as this has a direct effect on the stock market. Companies borrow funds from banks to grow their business so an interest rate rise would increase their loan payment obligations. Rising interest rates are especially alarming for REITS and utilities as these companies use debt extensively and higher bond yields will hurt their valuations.

Lauren Hua is a private client adviser at Fairmont Equities.

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