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The Dynamics of Bond Pricing

The Dynamics of Bond Pricing

  • Wilson Tomás • Research, Banco BIG Mozambique

Interest rates in the capital markets fluctuate with price fluctuations, often driven either by demand and supply mechanisms related to changes in investor expectations, or as a result of changes in monetary and fiscal policy in issuing countries or where issuers are based.

When there are changes in monetary policy – for instance, when the Central Bank increases the Reference Interest Rates (the MIMO rate in the case of Mozambique) – the price of Bonds falls. This fall in prices reflects a reduction of liquidity in the market, since i) investors have other alternatives for investing their capital, withdrawing it from the securities they hold, ii) commercial banks retain a greater percentage of their assets at the Central Bank, and iii) the credit conditions available to the economy worsen. All these situations tighten market conditions, resulting in higher interest rates.

On the other hand, changes in the balance between demand and supply can also result in higher interest rates. When issuers’ need for capital increases, more securities are issued into the market which may not be fully absorbed by existing investors. To buy up the available supply, investors demand higher rates of return to take advantage of the imbalance in demand, driving up interest rates once again.

This behaviour has a direct impact on the financial assets that make up the portfolios of Mozambican investors, since these are mainly made up of debt securities and time deposits. The rise in interest rates has a negative effect on bond prices, as there is a direct relationship between the two variables.

The relationship between the price of a bond and the interest rate derives from the fact that the price per bond is the sum of the cash flows, discounted to the present date, that the bond will have during its life. Any change in the yield results in a change of the bond price, as the sum of the cash flows will increase or decrease as they are discounted. The price of bonds, especially fixed rate bonds, always incorporate the expectations that investors have for the future evolution of interest rates, and will change whenever there are changes in those expectations. Rising rates will reduce the price of the bond and falling rates will have an inverse effect. For example, for a bond with a fixed rate coupon, which is trading in the market at a price of 100%, the yield will equal the coupon rate. If interest rates for assets of equal risk in the market rise, this bond can be expected to trade below 100%, generating less potential capital gains for investors who bought it at 100%. If interest rates fall, the movement will be the opposite and the bond will trade above 100%, generating potential capital gains for investors who have bought it at 100%.

Therefore, and taking into consideration the positive correlation between yields and the Central Bank’s monetary policy reference rate, the strategic positioning of an investor in a scenario of an increase in the reference interest rate should take into account the impacts of this increase on the composition of the portfolio of assets.

In the case of passive investors – those who normally invest in long-term assets and hold them until maturity – a rise in interest rates will have a negative impact on their current portfolio, but will allow them to add new assets at higher interest rates, thus increasing the average profitability of their portfolio. On the other hand, if the investor opts for an active management of his portfolio, when he anticipates a rise in interest rates he can resort to the capital market to get rid of securities with a greater potential devaluation and invest in more profitable assets according to current market conditions.

The secondary market meets the needs of investors who opt for active management of their portfolios, whether for liquidity, rebalancing or trading purposes. Investors using passive management can also use the secondary market to invest in assets already issued and which, after incorporating the new market conditions, seem more appropriate to their portfolio.

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