Chapter 30: Problem 6

The Federal Reserve just lowered interest rates. Explain the effect on bond prices.

Short Answer

Expert verified

Answer: When the Federal Reserve lowers interest rates, bond prices tend to increase. This is because existing bonds with higher coupon rates become more attractive to investors due to the low-interest-rate environment. As a result, the demand for these bonds increases, leading to higher bond prices.

Step by step solution

Understand the mechanics of bonds

A bond is a debt security issued by governments or corporations to raise funds. When an investor purchases a bond, they are essentially lending money to the issuer for a specific period, or until the bond matures. In return, the issuer pays periodic interest payments (known as coupon payments) to the bondholder, and the face value of the bond is paid back upon maturity. The coupon rate is usually expressed as a percentage of the bond's face value.

Interest rates and bond prices

The relationship between interest rates and bond prices is inverse. When interest rates increase, bond prices decrease, and vice versa. This happens because when interest rates are lower, existing bonds with higher coupon rates become more attractive to investors, as they cannot find better interest rates elsewhere. Thus, they are willing to pay a premium for these bonds, pushing up their prices. Conversely, when interest rates increase, fixed-interest payments from existing bonds become less attractive compared to newer bonds with higher coupon rates. Therefore, the demand for existing bonds declines, causing their prices to drop.

Federal Reserve's impact on interest rates

When the Federal Reserve - the central bank of the United States - lowers interest rates, it generally reduces the federal funds rate, which is the rate at which banks lend reserve balances to other banks overnight, and this affects other interest rates throughout the economy. By lowering interest rates, the Federal Reserve is essentially making borrowing money cheaper, which is expected to encourage spending and stimulate economic growth.

Analyzing the effect of lower interest rates on bond prices

With lower interest rates implemented by the Federal Reserve, the cost of borrowing decreases, and people tend to save less and invest more. The demand for existing bonds with higher coupon rates will increase, as new bonds will have lower coupon rates due to the low-interest-rate environment. This increase in demand for bonds with higher coupon rates leads to a rise in their prices.

Conclusion

In summary, when the Federal Reserve lowers interest rates, it has the following effects on bond prices: 1. Existing bonds with higher coupon rates become more attractive to investors. 2. Demand for these bonds increases, leading to higher bond prices. 3. New bonds are issued with lower coupon rates in the low-interest-rate environment, reinforcing the attractiveness and demand for existing, higher-coupon-rate bonds.