Question

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

Ans - Short term interest rates are usually controlled by central banks across the globe. short term interest rate is a type of rate which affects the short term borrowing between financial institutions or it is the rate at which government paper is bought or sold in the market. where long term interest rate is not controlled by the central government it is determined by the market forces( demand and supply).

There are two types of risk which bond investor must be aware of interest rate risk and credit risk. credit risk is the default risk and interest rate risk is the risk when there is a change in the price of the bond due to changes in the interest rate.

When short term interest rates are increased then the investor sees the bonds market as less lucrative which in turn leads to a decrease in bond prices also long terms bonds have long term maturity, therefore, they are at higher interest rate risk which leads to decrease in their prices as well. Therefore an increase in interest rates has a greater negative impact on long term bonds than the short term. There is an inverse relationship between the Interest rate and bond prices.

Treasury bonds are issued by the government and since it is issued by the government investors have a lot of faith in that type of bonds so treasury bonds are considered to be risk-free securities and it does fluctuate due increase or decrease in short term interest rate.

on the other hand, corporate bonds react opposite to the interest rate that means when the interest rates increase the prices of their corporate bonds will fall and when interest rate decrease the prices of their bonds will go up.

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