EC No, Bonds Aren’t Overvalued. They’re A Warning Sign

However, with existing bonds traded on secondary markets, the price is determined by the difference between the coupon rate and prevailing rates for similar obligations. The benchmark rate acts as the baseline.

A Very Basic Example

Let’s review an example.

Bond A:

  • Current benchmark interest rates = 5%
  • A $1000 bond gets issued at 100.00 (par) with a 5% coupon with a 12-month maturity.
  • At the end of 12-months, Bond A matures. $1000 gets returned to the lender with $50 in interest, equating to a 5% yield.

For the person who loaned the money, the 5% coupon for 12-months is sufficient to offset various market and economic risks.

Now, let’s assume the benchmark interest rate falls to 4%.

  • What is the “fair value” of Bond A in a 4% rate environment?
  • Since the fixed coupon is 5%, the price must change adjust the “yield at maturity.”
  • In this case, the price of Bond A would rise from $100 to $101.
  • At maturity, the principal value of $1000 gets returned along with $50 in interest to the holder.
  • However, if the bond was sold at $1010 ($1000 x 101%), there is a loss of $10 in value ($1010 – $1000) at maturity. Such equates to a net return of $1000 +($50 in interest – $10 loss in principal = $40) = $1040 or a 4% yield.

Got it?

The chart below shows the 10-year Treasury yield as compared to BBB to AA Corporate Bond rates. Not surprisingly, as the credit rating declines, the spreads between the “risk-free” rate and the “risk” rate increase. However, except for the bond market freeze during the “financial crisis” and “Covid shutdowns,” the ebb and flow of yields primarily track the “risk-free” benchmark rate.

Since rates are generally tied to a primary benchmark, for bonds to become overvalued, the benchmark rate would have to become detached from the underlying metrics that drive the level of borrowing costs.

Is that the case now?

Rates Are A Function Of The Economy

As I have discussed many times in the past, interest rates are a function of three primary factors: economic growth, wage growth, and inflation. The relationship, shown below, should not be surprising given that, as stated above, the “rate” charged for lending money must account for economic growth and inflation.

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William K. 1 month ago Member's comment

Interesting and profound! In addition, that statement,"While Central Bank interventions boost asset prices in the short-term, there is an inherently negative impact on economic growth in the long term." is so very correct, at least as it applies to the majority of folks. Based on the results over the past 60 or so years, if we look at real growth instead of inflated price growth, the benefit has not been there for a large portion of the population.

So it will be very educational to see what the future actually does bring.