Question

In the market for Amazon.com bonds, explain how each of the following events, ceteris paribus, would affect (1) the demand curve for the bonds, (2) the price and (3) the yield? a. Fitch upgrades the bond from AA to AAA. b. The interest rate on U.S. government bonds decreases. c. People expect the interest rate on U.S. government bonds to decrease, but it hasn't yet happened.

Short answer

Event a: (1) Demand curve shift rightward/upward (2) Price increases (3) Yield decreases. Event b: (1) Demand curve shift rightward/upward (2) Price increases (3) Yield decreases. Event c: (1) Demand curve shift rightward/upward (2) Price increases (3) Yield could remain unchanged until market adjustments.

Step-by-step solution

Event a: Fitch upgrades the bond from AA to AAA

When the credit rating of a bond is upgraded, it shows the bond issuer (Amazon.com in this case) has a lower risk of defaulting. This tends to increase the demand for the bonds, as they are now perceived as safer investments. An increase in demand, ceteris paribus, will lead to a price increase. As bond prices increase, their yields decrease (given that bond prices and yields move in opposite directions). Therefore, (1) the demand curve for the bonds shifts rightward/upward, (2) the price increases and (3) the yield decreases.

Event b: The interest rate on U.S. government bonds decreases

If the interest rate on U.S. government bonds decreases, this makes them less attractive relative to other bonds like Amazon.com's. So, more people would want to buy Amazon.com bonds, increasing their demand. This increase in demand would raise the price of Amazon.com bonds. As bond prices and yields move in opposite directions, this would lower the yield of Amazon.com bonds. Therefore, (1) the demand curve for the bonds shifts rightward/upward, (2) the price increases and (3) the yield decreases.

Event c: People expect the interest rate on U.S. government bonds to decrease, but it hasn't yet happened

If people expect the interest rate on U.S. government bonds to decrease, they might start buying other bonds like Amazon's, expecting these to be relatively more attractive. This increase in demand for Amazon.com bonds would raise their price. However, if the expected decrease in U.S. government bond interest rates hasn't yet happened, the yields of Amazon.com bonds could remain unchanged until the market processes the expectations into actual lower rates. Thus, (1) the demand curve for the bonds shifts rightward/upward, (2) the price increases and (3) the yield could remain unchanged until the market adjusts for these expectations.

Key concepts

Understanding the Bond Demand Curve

The bond demand curve captures the relationship between the price of bonds and the quantity demanded by investors. When events occur that make bonds more appealing, such as an upgrade in credit rating, investors' willingness to purchase at various prices changes. For instance, when Fitch upgraded Amazon.com bonds from AA to AAA, which signifies a reduced risk of default, investors naturally gravitated towards these safer assets, resulting in a rightward or upward shift in the demand curve.

This alteration in demand implies that for the same yields, investors are now ready to pay a higher price, illustrating an increased confidence in the issuer's ability to fulfill bond obligations. If we present the demand curve graphically with the price on the vertical axis and quantity on the horizontal, this shift would be plotted as a new curve to the right of the original one, representing an uptick in demand at each price point.

Navigating Bond Price Fluctuation

Bond price fluctuations are a core characteristic of the bond market and understanding them is crucial for any investor. Several factors contribute to changes in bond prices, and these can be interest rate movements, credit rating changes, or market expectations, among others.

Credit Rating Influence

When Amazon.com's rating was upgraded by Fitch, the bond's price increased due to higher demand, a typical outcome when the perceived risk decreases.

Impact of Interest Rates

If interest rates on U.S. government bonds decrease, investors often look for alternative bonds with higher yields, like Amazon.com bonds, causing their prices to escalate due to increased demand. The inverse relationship between prices and yields becomes evident here, as higher prices driven by demand result in lower yields for new buyers.

Deciphering Bond Yield Changes

Bond yields are affected by various market dynamics, and they are imperative to understand for monitoring investment returns.

The Impact of Ratings

Take, for instance, the upgrade of Amazon.com bonds from AA to AAA, which, as it makes the bonds more desirable, pushes their prices up and brings their yields down. This inverse relationship is a fundamental principle of bonds; as the price you pay for a bond increases, the return you receive – the yield – decreases, assuming the bond's payment terms remain unchanged.

Expectations of Interest Rates

Market expectations can also play a significant role. If investors anticipate a future drop in U.S. government bond yields, they might flock to corporate bonds like those from Amazon.com, raising their price and potentially reducing their yields, anticipating that these might offer better returns in the short term before any actual rate change materializes.