Question

Imagine that in a given point in time the implied yield to maturity is equal to 3%. Explain what happens to the interest rate paid by the US government bonds and the bond prices in the following scenarios.

i) The US government chooses to increase government spending to finance a new war

ii) Foreigners, in the wake of a new war - start searching for relatively safer assets

iii) A favorable economic outlook suggests that business prospects improve leading to a reduction in the odds of default on corporate bonds

iv) A change in the tax code makes municipal bonds subject to tax at the Federal level.

v) Individual Chinese investors are not longer allowed to allocated their funds in foreign countries

vi) European Union started to issue a new EU-wide bond

Answer 1

Bond price and interest rate are inversely related, so higher (lower) price will lower (raise) interest rate, and vice-versa.

(i) Higher government spending will increase government borrowing, raising budget deficit (or lowering budget surplus), requiring higher borrowing for deficit financing purposes, which will increase interest rate. Therefore bond price will decrease.

(ii) Political stability in US will increase the demand for US bonds, which will shifting bond demand curve rightward, increasing bond price. Therefore interest rate will decrease.

(iii) Lower risk of default will increase the demand for corporate bonds and decrease the demand for US government bonds, shifting its demand curve leftward, decreasing price. Therefore government bond interest rate will increase.

(iv) Taxability of Muni bonds will decrease their demand, shifting its demand curve leftward, decreasing price. Therefore government bond interest rate will increase.

(v) Chinese investors not being allowed to invest abroad, including in US, will decrease the demand for US government bonds, shifting its demand curve leftward, decreasing price. Therefore government bond interest rate will increase.

(vi) Issue of EU bond will decrease the demand for US government bonds, shifting its demand curve leftward, decreasing price. Therefore government bond interest rate will increase.