How Interest Rates and Inflation Impact Bond Prices and Yields

Owning a bond means receiving a stream of future cash payments; generally, periodic interest and the return of principal at maturity. But the value of those payments depends on more than just time; it's influenced by interest rates, inflation expectations, and the return investors require.

Because bond prices move inversely to interest rates and are sensitive to inflation, understanding how these forces interact is essential to evaluating a bond's yield and market value.

This article breaks down how bond pricing works, the role of yields, and the impact of inflation and rate changes on your bond investments.

Understanding Interest Rate and Credit Risks in Bonds

There are two primary risks that must be assessed when investing in bonds: interest rate risk and credit risk. Though our focus is on how interest rates affect bond pricing (otherwise known as interest rate risk), a bond investor must also be aware of credit risk.

Interest rate risk is the risk of changes in a bond's price due to changes in prevailing interest rates. Changes in short-term versus long-term interest rates can affect various bonds in different ways, which we'll discuss below. Credit risk, meanwhile, is the risk that the issuer of a bond will not make scheduled interest or principal payments. The probability of a negative credit event or default affects a bond's price – the higher the risk of a negative credit event occurring, the higher the interest rate investors will demand in exchange for assuming that risk.

Bonds issued by the U.S. Department of the Treasury to fund the operation of the U.S. government are known as U.S. Treasury bonds. Depending on the time until maturity, they are called bills, notes, or bonds.

Investors consider U.S. Treasury bonds to be free of default risk. In other words, investors believe that there is no chance that the U.S government will default on interest and principal payments on the bonds it issues. For the remainder of this article, we will use U.S. Treasury bonds in our examples, thereby eliminating credit risk from the discussion. 

How to Calculate Bond Yield and Price Effectively

To understand how interest rates affect a bond's price, you must understand the concept of yield. While there are several different types of yield calculations, for the purposes of this article, we will use the yield to maturity (YTM) calculation. A bond's YTM is simply the discount rate that can be used to make the present value of all of a bond's cash flows equal to its price.

In other words, a bond's price is the sum of the present value of each cash flow, wherein the present value of each cash flow is calculated using the same discount factor. This discount factor is the yield. When a bond's yield rises, by definition, its price falls, and when a bond's yield falls, by definition, its price increases. 

Exploring Bond Yields and Their Relationship to Maturity

The maturity or term of a bond largely affects its yield. To understand this statement, you must understand what is known as the yield curve. The yield curve represents the YTM of a class of bonds (in this case, U.S. Treasury bonds).

In most interest rate environments, the longer the term to maturity, the higher the yield will be. This makes intuitive sense because the longer the period of time before cash flow is received, the greater the chance is that the required discount rate (or yield) will move higher. 

How Inflation Shapes Investors' Yield Expectations

Inflation is a bond's worst enemy. Inflation erodes the purchasing power of a bond's future cash flows. Typically, bonds are fixed-rate investments. If inflation is increasing (or rising prices), the return on a bond is reduced in real terms, meaning adjusted for inflation. For example, if a bond pays a 4% yield and inflation is 3%, the bond's real rate of return is 1%.

In other words, the higher the current rate of inflation and the higher the (expected) future rates of inflation, the higher the yields will rise across the yield curve, as investors will demand a higher yield to compensate for inflation risk.

Note that Treasury inflation-protected securities (TIPS) can be an effective way to offset inflation risk while providing a real rate of return guaranteed by the U.S. government. As a result, TIPS can be used to help battle inflation within an investment portfolio.

The Interaction Between Short- and Long-Term Interest Rates and Inflation

Inflation and expectations of future inflation are a function of the dynamics between short-term and long-term interest rates. Worldwide, short-term interest rates are administered by nations' central banks. In the United States, the Federal Reserve's Federal Open Market Committee (FOMC) sets the federal funds rate. Historically, other dollar-denominated short-term interest rates, such as LIBOR or LIBID, have been highly correlated with the fed funds rate.

The FOMC administers the fed funds rate to fulfill its dual mandate of promoting economic growth while maintaining price stability. This is not an easy task for the FOMC; there is always debate about the appropriate fed funds level, and the market forms its own opinions on how well the FOMC is doing.

Central banks do not control long-term interest rates. Market forces (supply and demand) determine equilibrium pricing for long-term bonds, which set long-term interest rates. If the bond market believes that the FOMC has set the fed funds rate too low, expectations of future inflation increase, which means long-term interest rates increase relative to short-term interest rates – the yield curve steepens.

If the market believes that the FOMC has set the fed funds rate too high, the opposite happens, and long-term interest rates decrease relative to short-term interest rates – the yield curve flattens.

Why Timing Matters for Bond Cash Flows and Interest Rates

The timing of a bond's cash flows is important. This includes the bond's term to maturity. If market participants believe that there is higher inflation on the horizon, interest rates and bond yields will rise (and prices will decrease) to compensate for the loss of the purchasing power of future cash flows. Bonds with the longest cash flows will see their yields rise and prices fall the most.

This should be intuitive if you think about a present value calculation – when you change the discount rate used on a stream of future cash flows, the longer until cash flow is received, the more its present value is affected. The bond market has a measure of price change relative to interest rate changes; this important bond metric is known as duration.

The Bottom Line

Interest rates, bond yields (prices), and inflation expectations are closely linked; when interest rates rise, bond prices usually fall, and vice versa. The extent of that impact depends on where a bond sits on the yield curve, since short- and long-term bonds react differently to rate changes.

Understanding this relationship and how factors like duration and yield to maturity reflect a bond's sensitivity to shifting rates helps investors navigate changing market conditions and make more informed bond investment decisions.