Factors That Influence Bond Rates

A bond is a kind of debt security, in which the party that sells the bond agrees to pay back the bond purchaser the initial investment, plus interest, at a later date. The bond’s rate is the amount of interest the bond issuer agrees to pay.

A number of factors, specific both to the general bond market and to the particular issuer, will influence the rate at which a bond is sold.

 

 

Interest Rates

When the interest rates charged by banks and other lenders rise due to broad economic factors, the interest rates on newly issued bonds will rise too to keep pace. Bonds that maintain lower interest rates in a market of high rates are less likely to sell, as investors are more likely to purchase bonds that can offer them a higher rate of return on their investment.

This forces bond issuers to raise their interest rates so they can sell all of their securities. By the same token, when interest rates fall, bond rates tend to fall as well.

 

Inflation

“Inflation” is defined as the general upward trend of prices paid by consumers for goods. When prices fall, this trend is known as “deflation.” Typically, inflation and interest rates move in direct proportion to each other: As inflation rises, interest rates rise as well; when inflation slows or deflation occurs, interest rates fall.

When inflation is high, investors expect to be able to purchase less with the money they receive in the future; they will therefore invest in those bonds whose interest rate is greater than the inflation rate. Also, high inflation will often increase the number of borrowers needing money, which pushes up the price paid for bonds due to the increase in demand.

 

Financial Performance of Issuer

Investors who purchase bonds want to be assured that the issuer of will be able to pay back their investment. Those issuers that are in solid financial shape are thought to have a greater likelihood of not defaulting on their loans.

Because they are considered a safe, low-risk investment, these issuers can sell the bonds at a lower interest rate. Those issuers that are less healthy financially, and therefore have a greater chance of defaulting on their loans, are often required to offer higher rates of return to provide investors some incentive for taking a higher risk.

 

Market Volatility

Often, demand for certain types of bonds will rise due to market instability. If the prices in other asset classes, such as stocks and commodities, are fluctuating rapidly, investors will often move their money to safer assets, such as low-risk bonds. As demand rises, these bonds are able to command higher interest rates.

 

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