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What Is the Relationship Between Bond Prices and Interest Rates?

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Synopsis:

The bond market can be quite volatile where the effect of interest rates is concerned. Here is everything you need to know about the relationship between the bond price and interest rates to help you invest better.

How Does Bond Work

Bonds are debt-based assets that corporations and companies take out. Here are more details about bonds:

  • With the help of bonds,  individuals loan money to a government or corporation. 

  • This money is loaned on the condition that the corporation or government will return the full loan amount to the investor when the bond matures or expires

  • Apart from this payment, the investor also receives regular interest payments from the borrower on the amount loaned.

  • This is known as a bond’s coupon payment and is paid annually.

  • At the time of the full and final return of the money invested, any coupon payments that are due should also be cleared by the borrower.

  • Here is an example of how a bond's coupon works:

  • For example, a bond that has a value of ₹1,00,000 has a 5% interest rate 

  • As a result, investors who have purchased the bond will receive ₹5,000 as the bond coupon annually. 

  • This will continue till the bond matures or expires. 

  • If a bond’s maturity is 10 years after its purchase then investors will receive a total ₹50,000  as the interest amount plus the full amount invested back when the bond matures.

  • A bond’s coupon is a fixed amount. 

  • However if the interest rates available elsewhere increase or decrease, the bond’s demand and price will shift. 

Understanding Bond Prices and Interest Rates

Bond prices and interest rates have an inverse relation to each other. Here is everything you need to know about the two.

  1. New bonds with higher interest rates affect the ones that exist in the market at that time

  2. When new bonds are issued that have a higher interest rate, then the price of existing bonds will decline

  3. This is because the demand for the existing bonds falls as every investor would prefer bonds that offer them a higher interest rate. 

  4. Inversely, when the interest rate of the new bonds issued is lower than the interest of the existing bonds in the market, the demand and price of the latter will increase

  5. Any changes in the price of the existing bonds according to the interest rates are calculated depending on the bond’s existing future cash flows. 

Factors Influencing Bond Prices

Bond prices can be affected by four factors. Below is a list.

  1. Interest rate risk

    • This risk arises when investors want to sell a bond before it matures 

    • During this time investors need to consider interest rates. 

    • Usually, when a bond’s interest rate is higher than general interest rates, it will pull in more  investors keen to buy it

    • However, when selling a bond before its maturity date, even with the high interest rates, investors could end up selling it for less than they paid for it.

  2. Inflation risk

    • Inflation risk can be described as the risk many investments face when the return earned on them doesn’t keep pace with inflation. 

    • With a rise in inflation, bond prices fall and inversely with a fall in inflation, bond prices rise. 

    • So basically, upon the maturation of the bond, the return received will be less in the current currency. 

  3. Market risk

    • Market risk happens when the entire bond market declines. 

    • In such a situation bond prices will fall irrespective of the quality or type of bond

    • With the market risk, when investors want to sell their bond before maturity, the chances of them getting less value for it than they paid are high.

  4. Credit risk

    • Bond issuers and specific bonds come with their credit ratings. 

    • Credit ratings are a mark of the credibility of an issuer where interest payments and repayment of principal amount is concerned.

    • The higher the credit rating, the more likely payments will be made on time 

    • When an issuer’s rating rises so does the price of their bonds. 

    • When ratings go down, bond prices drop. 

What happens to Bond Prices when Interest Rates Rises?

Here are a few things that will happen when interest rates rise:

  1. With rising interest rates the price of existing bonds in the market will decline

  2. This price decline is because of the decrease in the demand for the existing bonds since every investor will always gravitate towards bonds offering a higher interest rate for them. 

What happens to Bond Prices when Interest Rates fall?

Here are a few things that will happen when interest rates fall:

  1. When the interest rate falls below the interest of the existing bonds in the market, the demand and price of the existing bonds will increase

  2. The principle here is the same as when interest rates rise. Investors prefer bonds that have a higher interest rate as they will provide them with higher returns.

Real-World Examples and Scenarios

Here are a few real-world examples of cases where interest rates rise or fall.

In case of a rise in interest rates:

  1. If an investor owns a bond paying a 5% interest/coupon rate. 

  2. Now new bonds are issued having a 6% interest/coupon rate 

  3. Since there is an increase in interest rates, the existing bonds with less interest rate now become less attractive. 

  4. Getting a full price for a bond with less interest will be very difficult

  5. As a result, to sell a bond, discounts would need to be offered, thus causing a drop in its price.

In case of a fall in the interest rates:

  1. If an investor owns a bond paying a 5% interest/coupon rate. 

  2. Now new bonds are issued having a 4% interest/coupon rate 

  3. Since there is a decrease in interest rates, the existing bonds with higher interest rates now become more attractive. 

  4. For such a bond, Investors will be willing to pay a premium 

  5. Selling a bond during such a time will provide higher gains

Practical Implications for Investors

With the changes in the interest rate in the market, the price of bonds. Here are a few practical implications investors will have accordingly:

  1. Bonds with a longer maturity are more affected by changes in interest rates

  2. The reason for this is because investors discount their cash flows. 

  3. Bonds having a longer maturity provide higher yields to investors because of interest rate risk.

Conclusion

Investors must understand how the bond market works, including the relationship between bond prices and interest rates. All aspects of the market are affected by economic policies and geo-political events. With a sound understanding of the relationship between bond prices and interest rates, investors can respond better to any potential economic changes and customize their investment strategy accordingly to prevent any losses.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

Frequently Asked Questions

Why do bond prices and interest rates have an inverse relationship?

Answer Field

New bonds with higher interest rates affect the ones that exist in the market and the price of existing bonds will decline. As a result, the demand for the existing bonds falls.

Inversely, when the interest rate of the new bonds issued is lower than the interest of the existing bonds in the market, the demand and price of the latter will increase

How does bond work in the stock market?

Answer Field

Bonds are debt-based assets that corporations and companies take out. Here are more details about bonds:

  • With the help of bonds,  individuals loan money to a government or corporation. 

  • The corporation or government will return the full loan amount to the investor when the bond matures or expires

  • The investor also receives regular interest payments from the borrower on the amount loaned known as a bond’s coupon payment and is paid annually.

  • At the time of the full and final return of the money invested, any coupon payments that are due should also be cleared by the borrower.

What role do coupon rates play in determining bond prices relative to interest rates?

Answer Field

When the coupon rate of a bond is higher than the prevailing interest rate, the bond's price rises and if the coupon rate of a bond is lower, the bond's price falls.

Can bond prices go up when interest rates rise?

Answer Field

No. In most cases, bond prices will fall when the interest rate rises.

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