Why Bond Prices Fluctuate | Closing The Gap
Dec 18, 2015
By: Sage Anderson
The tastytrade financial network is proud to have the CME Group as a sponsor for one of its most closely-followed programs - Closing the Gap: Futures Edition.
Today on the blog we are happy to present a recent episode from this series that focuses on bond prices and the reasons they fluctuate.
Bonds represent a unique asset class and therefore move up and down based on specific market levers. Unlike equities, which represent a degree of ownership in an organization, bonds are much more like an IOU.
Investors lend their money to companies in the form of bonds and are in return promised interest on that loan in addition to repayment of the principal. The financial strength of a company as well as prevailing market conditions will dictate the rate of interest that is paid to investors.
The interest rates set by the Federal Reserve for short-term government securities have a significant impact on the rates set by companies issuing bonds. If interest rates governed by the Federal Reserve are in a rising cycle, companies will theoretically have to increase the interest rate they offer investors in order to attract demand.
The above helps explain why the direction of interest rates is inversely correlated to the price of bonds. When interest rates are rising, previously issued bonds drop in value because future issues will theoretically be relatively more attractive (pay higher rates).
On this particular episode of Closing the Gap: Futures Edition, Pete Mulmat joins hosts Tom Sosnoff and Tony Battista to further enlighten listeners on the mechanics behind the fluctuations in bond prices.
During this discussion, the Closing the Gap team introduces another important concept related to bond prices - the yield curve. And don't let this relatively simple concept throw you for a loop due to its complex-sounding name.
The yield curve is the graphical representation of interest rates over time.
In low interest rate environments, the yield curve will often steepen going further out in time due to the expectation that interest rates will rise. The reverse situation is known as an inverted yield curve - when interest rates are expected to decline over time.
Given that interest rates in the United States have been hovering around zero for roughly seven years, the current yield curve is of the "normal" variety - meaning it steepens over time (interest rates are expected to rise).
Because the yield curve shifts dynamically with changes in expectations for the future movement of interest rates, what is actually observed is a range for the yield curve over time.
Pete, Tom and Tony discuss this concept in depth on the segment and introduce the graphic below which illustrates the breadth of the yield curve since the start of 2015:
Adding context to the above, it's important to note that short-term interest rates are controlled by the policies of the Federal Reserve, whereas longer-term interest rates are shaped by market participants.
Given the above information, we can now return to the original question - why do bond prices fluctuate?
The answer is that although the Federal Reserve sets short-term interest rates, the market shifts dynamically around the uncertainty of potential changes in interest rate policy. While the market may have a good idea that interest rates will rise, the speed and degree of any potential increase is an unknown.
Because yield curve expectations are ever-changing, so too are bond prices.
The guys take the above concept to the next level on Closing the Gap: Futures Edition. They discuss not only the "why" of bond price fluctuation, but also the "how much?"
Specifically, they ask the question, "how much will a bond's price change in response to an interest rate increase?" They answer the question by introducing a quoted number available on the CME website called the Dollar Value of a Basis Point (DV01). This is a value similar to "delta" in options trading that provides further context around the potential impact of future interest rate changes.
The chart below, discussed in detail on the show, provides background on DV01 and how it can be applied to estimated interest rate changes by the Federal Reserve:
Comparing the forecasted 174-point move calculated in the above graphic to previous movement in 2015 helps illustrate just how significant a 25 basis point interest rate increase could be:
/ZB 2015 Daily Ranges (High-Low):
Average: 56 ticks
Max: 140 ticks
Median: 51 ticks
The above means that any actual decision by the Federal Reserve to raise rates would likely catalyze the largest move of the year in the /ZB.
To learn more about bond prices and why they fluctuate, we invite you to watch the entire episode of Closing the Gap: Futures Edition on tastytrade when your schedule allows.
In the meantime, we encourage you to follow-up with any questions or feedback at email@example.com.
We thank you for being the most important part of the tastytrade community!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”). tastytrade is a trademark/servicemark owned by tastytrade.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.
Small Exchange, Inc. is a Designated Contract Market registered with the U.S. Commodity Futures Trading Commission. The information on this site should be considered general information and not in any case as a recommendation or advice concerning investment decisions. The reader itself is responsible for the risks associated with an investment decision based on the information stated in this material in light of his or her specific circumstances. The information on this website is for informational purposes only, and does not contend to address the financial objectives, situation, or specific needs of any individual investor. Trading in derivatives and other financial instruments involves risk, please read the Risk Disclosure Statement for Futures and Options. tastytrade is an investor in Small Exchange, Inc.