Fixed Income Fund NAV determinant: Simplified

Assume last year inflation rate is at 3%. You bought a 6% coupon bond with $ 10,000 which repays you in 2 years. So your real net return was (6-3) = 3% annually. 
This year, inflation rate goes up to 6%. . No one wants to buy the same bond you have now for $ 10,000 because the real net return is 0%. 

To attract buyers, the bond issuer needs to sell the bond at a discount. This means, new buyers still get 6% coupon payment on $ 10,000, but they only pay upfront, say, $ 9,500. They will be repaid $ 10,000 2 years from now. Conversely, if inflation rate goes down to 1% this year, the bond you bought last year becomes even more  irresistible now due to a net return of (6-1) = 5% per annum. Everyone now wants a piece of the action – new buyers will rush to buy this bond. Based on the law of supply and demand, this drives the bond price up. Hence, the bond is said to be trading at a premium, say, at $ 10,500. New buyers will still get 6% coupon payment on $ 10,000, but now they pay upfront $ 10,000. They will be repaid $ 10,000 2 years from now.

This fluctuation of bond prices is the main factor affecting the NAV of fixed income security/fund.

*Inflation rate and interest rate are positively correlated.

1 thought on “Fixed Income Fund NAV determinant: Simplified”

  1. Hence yield & bond prices are somewhat inversely in relationship 😛

    Although there are known anomalies in certain period of time due to environment circumstances.

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