Have you ever noticed bond prices decline when bank market interest rate rises? Or whenever there is an economic downturn or recession bond prices go up or rising interest rate could be destructive for bond prices. These are few of the questions we will try to answer in this short and easy to understand article.
Basics of Bonds: Before we move further let us try to have some basic understanding of bonds.
- Coupon Interest rate: The coupon rate is the interest rate that the issuer of the bond promises to pay to the bondholder. If the coupon rate is 5%, the issuer of the bonds promises to pay $50 in interest on each bond per year.
- Par value: The par value is also known as the face value of the bond, which is the amount that is returned to the investor when the bond matures. For example, if a bond is bought at issuance for $1,000, the investor bought the bond at its par value. At the maturity date, the investor will get back the $1,000.
- Discount Value: Bonds do not necessarily issued at their par values. They may be issued above or below their par values. Any bond issued below $1,000 let us say at $ 950 is said to be issued at a discount.
- Premium Value: If a particular bond is issued at value more than its par value is said to be issued at premium. E.G. any bond with face value of $ 1000 issued at $ 1100 is considered to be at premium.
An inverse relationship: Whenever new bonds are issued they are generally issued at a coupon rate which is supposed to be very close to the prevailing market interest rate. Interest rates and bond prices have an inverse relationship; so when one goes up, the other goes down. The question is: How does the prevailing market interest rate affect the value of a bond you already own or a bond you want to buy from or sell to someone else? The answer lies in the concept of opportunity cost.
Any investor who is looking for an opportunity to maximize the return from the current investments would keep comparing return with the opportunities elsewhere in the market. As market interest rate or the bank interest rate changes it makes the current investment within bonds either more or less attractive.
Interest rates and bond prices have an inverse relationship: Let us try to understand the relationship between bond price and interest rate with the help of an example.
Let us suppose the ABC Company offers a new issue of bonds carrying a 7% coupon and the prevalent market interest rate is also 7%. This means it would pay you $70 a year in interest. After evaluating your investment alternatives, you decide this is a good deal, so you purchase the bond at its par value: $1,000 as this is safer investment.
Whenever a coupon is issued at par value, coupon rate and bond yield are equal which is 7% in current scenario.
What if market interest rates go up? Let’s suppose market interest rates in general are 8%. Now to make investment in bonds attractive for the investors, company has to give investor some kind of discount.
The company ABC has to issue the bond at the discount price of $ 870 even though the face value of the bond is $ 1000 and coupon rate is 7%. In this case the bond yield will be equal to 8% even though coupon rate is 7%.
So we can say, whenever market interest rate goes up the bond prices will go down and bond yield goes up. Also, Bond yield will be greater than the coupon rate.
What if market interest rates go down? Now let’s suppose market interest rates in general falls to 6%. Now the investment within bond would be more attractive than to invest somewhere else within market which would drive the bond price up. To take the advantage of current market situations, the company ABC would sell its bond at premium price of $ 1166 even though face value of the bond is $1000 and coupon rate is 7%. In this case the bond yield will be equal to 6% even though coupon rate is 7%.
So we can say, whenever market interest rate goes down the bond prices will go up and bond yield goes down. Also, Bond yield will be less than the coupon rate.
Finally we can say, many other factors go into determining the attractiveness of a particular bond: the length of time until the bond matures, whether or not its interest is taxable, the creditworthiness of its issuer, the likelihood that the issuer will pay off debt early, and more. But the important thing to remember is that change occurs in market interest rates virtually every day. The movement of bond prices and bond yields is simply a reaction to that change.