Relationship between inflation, interest rates and bond prices

Inflation i.e. an increase in general price level of different goods and services is battled by different means for reducing it to comfortable levels. One such measure usually adopted by the apex body of India, Reserve Bank of India (RBI), is by reducing the money supply in the economy. In order to effect this the institution generally increases CRR and SLR requirements for banks which consequently lowers liquidity in the market.

Another way is to increase the repo rates (rates at which banks borrow from the RBI). An increase in these key rates push interest rate higher in the economy. Consequently, banks to whom now money is offered at a higher rate of interest by RBI (repo rate) pass on the same to consumers in the form of higher lending rates while increasing the rates on deposits as well simultaneously.

Now, the focus in the discussion shifts to the point as to how inflation and interest rates relate to bond prices and bond yield ?

Like other financial instruments that are affected by prevailing economic scenario, pricing and yield on bond also changes with change in important economic indicators including inflation. Though, government bonds floated by several public-run entities for mopping up funds are deemed safe with respect to principal and interest payment, the same include an inherent risk which is subjected to such external factors. The investor is more so affected by the change when he wishes to redeem the instrument before maturity.

Inflation with its cascading effect poses its impact on bonds and in general the prices of bonds head lower or drop following an increase in rate of inflation.

Why inflation and higher rate of interest push bond price down and yields higher?

As inflation rises, RBI tends to push interest rates higher by increasing the repo rate. When interest rates rise, bond prices fall and when interest rates fall, bond prices rise.

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