Bond Price Basics

• A bond is an IOU from the issuer. It can be held to maturity by its first purchaser, but it also can trade in a very active secondary market. An inverse relationship exists between the price of a bond on the secondary market and its yield. If doubts about the issuer's credit worthiness arise, for example, the price will depress, but that will necessarily increase the yield. In other words, if the price of a bond with a pay-off at maturity of $100 drops from $80 to $75, then the expected return increases from $20 to $25.
  
  

Expected Inflation Effects

• If potential buyers of bonds expect inflation to eat away at the value of bonds' pay-off in the period between issuance and maturity, then this expectation will make bonds a less attractive investment than otherwise; the demand for bonds will lessen.
  
  Lessened demand, if other factors are equal, lessens price. So this expectation lowers the price of bonds and, inversely, increases yields.
  
  For example, when President George W. Bush nominated Ben Bernanke to become the new chairman of the Federal Reserve in 2005, concerns that Bernanke might not be sufficiently tough on inflation helped to depress bond prices, lifting yields.
  
  

Erroneous Expectations

• During a period of double-digit inflation in the late 1970s, the U.S. financial markets came to expect more of the same. In October 1979, when Federal Reserve Chairman Paul Volcker, in the hope of squeezing inflation out of the economy, raised interest rates drastically through the Federal Reserve's control of the rate at which it lends money to banks (the discount rate), the market, in effect, bet that Volcker would fail. Yields rose. The three-month Treasury bill had yielded 8 percent before Volcker's announcement, but that figure climbed to 12.5 percent by the end of the year.
  
  

Dramatic Change

• The 1979 expectations, however, were in error. Volcker's move -- at the expense of a devastating recession that lasted until 1983 -- did squeeze inflation out of the economy. The market came around to a more accurate reading in spring 1980. The yield on a three-month Treasury had fallen to 8.58 percent by May and to 7.07 percent by June 1980.