Economic Growth and Bonds

[hassan.mahfooz]

Hi

What happens to bond yields and spreads when the economy strengthens in general? I have seen two different explanations in different readings:

1. CME: As the economy strengthens, the bond yields increase - negative for bond investors

2. Fixed Income: As the economy strengthens, the credit risk decreases, the credit spread goes down, the price increases. - positive for the bond investor.

Which explanation is more accurate?

[carcosa]

My take on this is CME is talking about govt bond yields, while the Fixed Income section you quoted is referring to corporates. This would make sense as we would expect govt yields to rise during an economic expansion and corporate spreads to tighten given the improving conditions. Hope that helps.

[kevinsfl]

1. CME: Economy strengthens, the Fed increases interest rates to control inflation. At the same time, a stronger economy means narrowing of credit spreads. The net effect for risky corporate bonds will be ambiguous (decrease in value due to increase in interest rates + increase in value due to narrowing of credit spreads). As for risk-free bonds (T-bonds), their value will decrease.

2. Fixed income. You are assuming that the Fed wont take any monetary action, so exclude interest rate effect from point 1, and you are left with only the effect of narrowing credit spreads.

[Viraj_Swaroop]

@kevinsfl

1. CME: Economy strengthens, the Fed increases interest rates to control inflation. At the same time, a stronger economy means narrowing of credit spreads. The net effect for risky corporate bonds will be ambiguous (decrease in value due to increase in interest rates + increase in value due to narrowing of credit spreads). As for risk-free bonds (T-bonds), their value will decrease.

2. Fixed income. You are assuming that the Fed wont take any monetary action, so exclude interest rate effect from point 1, and you are left with only the effect of narrowing credit spreads.

+1

[hassan.mahfooz]

1. In the exam, if a question is focusing on spreads in the context of economic growth, I would consider it a positive for bond investors due to tightening of spreads and upgrade of ratings.
2. However, if a question is focusing on yields and interest rate increase in the context of economic growth, I would consider it as a negative for bond investors.

Is this a good approach?

[hassan.mahfooz]

I quote

GDP: A large 9 percent annual increase in GDP would give rise to strong corporate profts and would represent a favorable economic environment for equity investors (positive equity impact).

However, such a strong economy would be a negative for corporate bond investors in that such economic growth and aggregate demand would place upward pressure on bond yields. In addition, in time, expectations of rising inflation could also hurt corporate bond investors (negative corporate bond impact).

[Viraj_Swaroop]

@hassan.mahfooz

1. In the exam, if a question is focusing on spreads in the context of economic growth, I would consider it a positive for bond investors due to tightening of spreads and upgrade of ratings.
2. However, if a question is focusing on yields and interest rate increase in the context of economic growth, I would consider it as a negative for bond investors.

Is this a good approach?

Lower rated (High yield) bonds outperform higher rated bonds when economy is strengthening.