Question

Respond to the following in a minimum of 175 words:

Discuss how the bond market reacts when the Federal Reserve increases short term interest rates. How do short-term versus long-term bond prices react? How do Treasury bonds versus corporate bonds behave?

Answer 1

The Federal Reserve exercise monetary policy by making changes in the short term interest rates.That rate is also called as Federal Fund rate. To control inflation, the interest rate will be increased and vice versa. The bond market reacts to the changes in the interest rates. When the interest rate increases, bond prices fall and when the interest rate falls, bond price increases.

Long term bonds are more sensitive to the interest rate changes than short term bonds. The reason is that the long term bond have longer maturity period and if the bonds are of near term bonds which has less number of coupon payments. More than that, there is high chances for fluctuations in the interest rates during this long period of time.

Treasury bonds offer stable interest rate for the investors than corporate bonds. Corporate bonds have higher interest rates. Corporate bonds are riskier than treasury bonds. But corporate bond perform better than treasury bonds.