Economics involves making choices based on maximization of utility, profit, or minimization of economic losses. In maximizing or minimizing economic factors in consumption or production or there are constraints to the achievement of economic goals and objectives. In economics, players act in self-interests to achieve various goals. This is extended in the bond market where various factor influence the demand and supply of bonds. The bond market usually fluctuates during various economic times though out the business cycle. Other economic factors change in different period such as during robust economic growth. Various factors that could change during the period of robust economy include default risk, wealth, as well as general business conditions. Changes on every one of these factors have influence on the supply and demand for bonds in the bond market. The influence on demand and supply of bonds come in when bond prices and bond yield changes. This aspect could be seen from the fact that bond prices seemingly fall during high economic growth but rises when economic growth is low. This paper analyses how the bond market is affected by economic fluctuation throughout the business cycle and especially during times of robust economic growth.
The law of demand and supply forms the fundamental economic laws. In the bond market, individuals selling bonds dictate their supply why buyers dictate the demand of the bonds. Bond suppliers usually supply bonds until a point is reached when profit is maximized with respect to the cost of selling the bonds in terms of interest rates, selling costs, and other related costs (Swedroe 2011). During robust economic growth, various economic factors also tend to improve greatly including wealth, improvement in risk factors, as well as positive changes in general business conditions. The factors affect the supply and demand for bonds. Wealth is an economic factor that influences the demand for assets generally. Bonds being assets are as well affected by wealth since it is a store of value.
During periods of high economic growth, risk factors are minimal and investors opt to store their increasing wealth in interest earning forms of wealth. The reason behind this is the evaluation of various factors in this kind of investment such as the relative returns, liquidity factors, and risk factors. During this time of economic growth people have high expectations and for various reasons, investors believe that the economy would be favourable and end up demanding more bonds thus increasing the demand for bonds (Conley 2013 ). Since the demand is very high at this time, market forces of demand and supply acts in a way to restore market equilibrium hence making prices to fall to equate bond demand and bond supply.
Default risk factors influence the demand and supply of bonds on a different perspective from wealth or business conditions. Default risk comes in when individuals and or organizations are unable to settle their debt obligations. This condition scares away bond issuers in fear that they may never get their debts settled. During periods of robust economic growth, businesses conditions seem favourable making bond suppliers have the will to sell their bonds in large quantities (Wright & Quadrini 2013). Bond suppliers are only taken aback by the falling prices of bonds during this time but hardly by the default risk factors. In the case of high default risk in the bond market, bond suppliers charge high interests as a way of mitigating the effects of default risk. While bond demand and supply is affected by wealth and default risk factors, expected inflation and general business conditions form the basis of the default risk and wealth influences on bond supply or demand (Swedroe 2011).
Inflation expatiations are responsible for lowering the value of money given that real income is nominal income compared to the prevailing price level in the economy (Stolper & Samuelson 1941). Inflation could be generated by increased government expenditure as part of general business conditions. The government may run out of funds and sell bonds increasing the supply bonds and hence increasing the yielding of bonds. On another aspect, favourable business condition may attract investors who may borrow money by selling bond. During the time of good business conditions, people want to invest in risk free assets whose returns are favourable (Gardiner 2013). Selling bonds could be a way of earning capital for investing in various areas of business. The effect of this is an increase in bond supply so that the price of bonds is forced to fall. As bond prices fall, bond yielding increases. This effect means that good business conditions are favouring factors to the bond market.
Holding a bond until maturity has no safety repercussion unless a government collapses or inflation strikes the economy. Inflation would have no effect if a given investment keeps pace with the inflation or does better than the effects obtained from the inflation. Inflation risk could be worsened by interest rate risk. Selling a bond before it matures would yield better returns if the prevailing interest rates were higher than the rates prevailing when purchasing the bond (Conley 2013 ). Since interest rate, an aspect of default risk, seems to influence bond demand and supply irrespective of the economic conditions, it follows that default risk is the best consideration a bond investor can make. Again, one has to understand that bonds are only agreement to repay a held debt and promises can be broken if a corporation or individual can go bankrupt. It is therefore wise to weigh the risks, which can be done using bond credit rating.
Robert Wright & Vincenzo Quadrini. 2013. What causes the supply and demand for bonds to shift? Retrieved February 22, 2013, from Money and Banking: http://catalog.flatworldknowledge.com/bookhub/reader/30?e=wright-ch05_s02
Conley, P. 2013. The Risks of Bond Investing: Understanding Dangers in Fixed-Income Investing. Retrieved February 22, 2013 , from bonds.about.com: http://bonds.about.com/od/bonds101/a/bondrisk.htm
Gardiner, K. 2013, February 15. Taking the easy way out? Retrieved February 22, 2013, from barclayswealthblog.com: http://barclayswealthblog.com/
Stolper, W. F., & Samuelson, P. A. 1941. Protection and Real Wages. The Review of Economic Studies, Vol. 9, No. 1 , 58–74.
Swedroe, L. 2011, December 7. A long-term look at default risk in bond markets. Retrieved February 22, 2013, from MoneyWatch: HYPERLINK “http://www.cbsnews.com/8301-505123_162-” http://www.cbsnews.com/8301-505123_162-57337933/a-long-term-look-at-default-risk-in-bond-markets/