Bonds, inflation and the economy

In 'What is net present value?' and 'What are bonds, treasuries and corporate debt?' we looked at bond basics and bond fundamentals. Here we look at more advanced types of bonds and how they are influenced by the economy and inflation.

Let's be clear about how bonds work. Bonds are purchased for the current value (CV) of their future cash flow values (FV). For short term bonds such as overnight, 13 weeks or 1 year instruments this isn't hard to calculate. But when you work with long bonds such as a 30 year bond you need to be highly accurate with one variable...the discount rate. To show consider a special type of bond called a zero coupon bond. This bond pays no annual interest, instead returning the nominal principal amount at a date in the future. Let's consider a 30 year $1 billion zero coupon bond, with a discount rate of 4.22% and 5.30%. How much would you pay for this particular bond?

CV = $1B/(1+0.0422)^30 = $212.4 million (or a 79% discount to nominal)
CV = $1B/(1+0.0530)^30 = $289.4 million (or a 71% discount to nominal)

So for a 1.08% difference in the discount rate, this bond gained or lost 8% or $77.0 million. If you think this is not likely, look at the chart below (www.yahoo.com). This shows the implied yield (discount rate) on a 30yr US treasury.
As you can see the market is uncertain about the discount assumptions to make for such a long period of time. To see how these discount rate uncertainties translate into bond prices, let's look at two long bond ETFs (Vanguard - TLV, and SPDR Lehman - TLO). As you can see bonds can be a volatile investment, particularly at the long end of the yield curve.
The level of bond yields (discount rates) at different timeframes tells you a lot about the economy. Consider the following chart from Mike 'Mish' Shedlock, one of my favourite bloggers.
Looking at the 3 and 5yr US treasuries, we can see how bond market traders in late 2000 switched from worrying about inflation (high discount rate) to worrying about a recession. This is because the bond discount rate is basically made up of the markets opinion about inflation and economic activity. Shown below is the 'yield curve' for July 2008. This shows the forward yield estimates (discount rate) for different treasuries at different timeframes. Click here to go to this site which also shows a dynamic yield curve corresponding to the S&P500 over the last 6 or so years. A great feature.
The bond punch line... finally.
The reason bonds are so important is that there are trillions of dollars in bonds outstanding. Bonds are used to fund government debt (huge for the US and EU), corporate debt (huge for financial companies) and private debt (home loans, credit card debt, student loans). The bond market is at the heart of the credit crisis because bond holder demand higher returns (interest rates) when inflation or uncertainty rises. This raises the cost of borrowing for EVERYONE and why the mandate of central banks is price stability which by default means low and steady bond yields.

Next the great moderation and peak-credit. Peak oil is an insect bite compared to peak-credit!