I seem to have a major misconception in my understanding of the bond market and how interest rates and demand and supply influence valuation levels. I hope someone will be able to clarify.
My thinking is as follows. If the fair value of a bond is the present value of the cash flows resulting from coupons and principal repayment, discounted at an interest rate that depends on a policy interest rates, how can the bond market be overvalued, given a specific set of interest rate levels?
I understand the idea of overvaluation in equity markets, where demand and supply freely determine prices, and demand may be artificially high in expectation of fiscal stimulus or because investors buy into unrealistic success narratives of specific companies. But in bond markets, the situation is a little more complex because both the policy interest rate and demand and supply feature in the valuation mechanism.
So my questions are the following:
- How to interest rate levels on the one hand and demand and supply on the other hand interact to determine the market price of bonds?
- Can the bond market be overvalued or can bond market valuations be inferred perfectly from policy interest rates?
- How can it be that bond markets are referred to in the media as overvalued when valuations depend on interest rates? Do they mean that market participants are assuming inappropriately low spreads to discount bond-related cashflows in valuation?
Thank you in advance for any clarifications you may be able to provide!