Relationship between Bond Price and Interest Rates


Ajit Kumar AJIT KUMARWISDOM IAS, New Delhi.

Interest rates and bond prices have an inverse relationship

When new bonds are issued, they typically carry coupon rates at or 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.
Investors constantly compare the returns on their current investments to what they could get elsewhere in the market. As market interest rates change, a bond's coupon rate—which, remember, is fixed—becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself.
 
Let's look at an example.
Suppose Company A offers a new issue of bonds carrying a 7% coupon. This means it would pay you Rs.70 a year in interest after investment of Rs 1000.
 
Now let's suppose that later that year, interest rates in general go up. If new bonds that cost Rs 1,000 are paying an 8% coupon—or Rs 80 a year in interest—buyers will be reluctant to pay the Rs 1,000 face value for your 7% Company A bond. In order to sell, you'd have to offer your bond at a lower price—a discount—that would enable it to generate approximately 8% to the new owner.

Similarly, if rates dropped to below your original coupon rate of 7%, your bond would be worth more than Rs 1,000. It would be priced at a premium, since it would be carrying a higher interest rate than what was currently available on the market.
Of course, 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 change occurs in market interest rates virtually every day. The movement of bond prices and bond yields is simply a reaction to that change.




Monday, 11th Jun 2018, 07:01:48 AM

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