Question

Is deflation bullish or bearish for the bond market? Explain your answer by showing which terms in the yield to maturity formula are affected and how these change.

Yield To Maturity (YTM) of a Bond While bonds have stated interest rates, those are not generally the yield that is followed in the bond market. Instead, an internal rate of return is used. We saw that the present value of the fixed income stream from the bond we discussed earlier was:

PV = 50/(1+r) + 50/(1+r)2 + … + 50/(1+r)5 + 1,000/(1+r)5

At any point in time, we know the price of the bond (Pb) from its value in the secondary bond market. If we equate this current bond price to the present discounted value of its fixed income stream:

Pb = 50/(1+r) + 50/(1+r)2 + … + 50/(1+r)5 + 1,000/(1+r)5

the only unknown value is r. If we solve this equation for r (after substituting the value of current bond price), we arrive at its Yield to Maturity (YTM): Yield to Maturity: the rate of discount that equates the present discounted value of the fixed income stream from a bond with its current price. - This reflects the return from this bond if purchased now and held until maturity.

Answer 1

When there is deflation, government reduces interest rates to encourage people to borrow and ensure there is more liquidity in the system. This leads to lowering of r in the above equation. As a result of this, the price of the bonds increase as the denominator goes down.

Thus deflation leads to increase in prices of bonds. So deflation is bullish for the Bonds Market.

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