Relationship Between Bond Yields, Interest Rates, and Inflation

Recently, bond yields rose when President Biden nominated Jerome Powell to continue as Federal Reserve chairman. Investors think that the Fed will be more aggressive on inflation under Powell. This would imply higher interest rates to control inflation. Since bond yields have a great bearing on the prices and performance of other assets like stocks, cryptocurrencies, and gold, it's important to understand what bond yields are and how they're determined.

A bond is a fixed income instrument that represents a loan made by an investor to a borrower. Most simply, a bond yield is a return that an investor realizes on a bond. A bond's current yield is determined by the bond’s price and its coupon or interest payment. This is usually different from the coupon rate, which doesn’t change much. The coupon rate is basically the annual coupon payment divided by the face value of the bond.

There's an inverse relationship between the yield and the price of a bond. As the price of the bond goes up, the yield falls, and vice versa. The price of a bond keeps changing almost on a daily basis due to prevailing interest rates. Lower interest rates make the bond paying a fixed interest rate more attractive, which leads to an increase in its price. Similarly, higher interest rates lead to a fall in bond prices.

The bond could sell in the market at a discount or a premium to its face value. Regardless of the market price of the bond, the coupon remains the same. As a result, the yield keeps on varying depending on the price of the bond.

The outlook for interest rates is the single biggest factor impacting bond yields. However, the changes in interest rates don't impact all of the bond prices in the same way. Bonds with longer maturity are more sensitive to the changes in interest rates. So, if interest rates rise, bonds with a higher maturity would fall more than a bond with a lower maturity. The phenomenon of bond prices reacting to interest rates is known as "interest rate risk."

Bonds that have a lower coupon are more sensitive to interest rates. So, if interest rates rise, bonds with a lower coupon would fall more, assuming that all other aspects of the bonds are similar.

Not just the direction of bond yields but its reason is important in determining the impact of bond yields on assets like stocks. Rising bond yields, for example, could be due to either strong growth expectations or high inflation expectations. Theoretically, higher bond yields mean a higher discount rate for companies’ future cash flows, which would have a negative impact on equities.

If bond yields are rising due to higher growth expectations, a higher discount rate could be more than set off for equities with higher growth expectations. That wouldn't be the case if inflation alone is leading to rising bond yields.

Precious assets like gold don't usually have a direct relationship with bond yields. However, they have a negative relationship with interest rates since higher rates make gold less attractive as an asset class and vice versa.

While it's always advisable to keep part of your portfolio in fixed-income assets like bonds, if you expect bond yields to rise, it's always prudent to position your portfolio in either floating rate bonds or in bonds that have a lower maturity.