Bond Prices and Interest Rates: Understanding the Relationship

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To someone new to investing in bonds, the relationship between bond prices and interest rates can be a tricky one to understand at first. In general, here is how the relationship works, all other factors being constant:

The easiest way to understand this inverse relationship is to look at a simple example involving a zero-coupon bond. This is a type of bond that, instead of making coupon (interest) payments to the bondholder each year, makes one lump sum payment at maturity. For instance, a zero coupon bond with a par value of $1,000 will be issued at a discounted price of $950. When the bond matures in one year, the bondholder receives $1,000, which equates to a 5.26% return on their principal (( $1,000 – $950 )/ $950 = 5.26%).

When an investor purchases this bond, it is implied that they are satisfied with receiving a 5.26% return on their money (since the $1,000 payment at maturity is a fixed outcome, assuming the issuer doesn’t default). Just like everything else, though, what else is happening in the market can influence prices. Suppose that one-year interest rates rose up to 8%. Investors who hold the bond yielding 5.26% will obviously be more attracted to the bond offering an 8% return, assuming all other factors are held constant in this example. Why would someone want 5.26% return when they could get 8%? As a result of the interest rate increase, many will sell their 5.26% bonds and roll the money into the 8% issues. This causes the price of the old bonds to fall- a classic example of supply and demand. As the value of the $950 bond yielding 5.26% continues to fall, the yield is increasing since the $1,000 maturity payment is fixed.

Suppose the weakening demand causes the price to fall to $935. At this lower price, the bond is now yielding 6.95%, which is closer to the prevailing interest rate in the market of 8%.

The same logic holds true for the opposite scenario. Imagine if the one-year interest rates fell to only 1%. Now the bonds that were yielding 5.26% look really attractive to investors. As such, demand increases for said bond, which causes what? THE PRICE GOES UP. And a higher price means what? You guessed it- a lower yield.

This is a very simple example (and in the real world, there are usually dozens of different factors at play), but it explains the general trend for the relationship between bonds and interest rates. So the next time you hear one of the talking heads on CNBC say that bond yields are rising, you know why they don’t sound optimistic- it’s because bond prices are falling!

 

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