Bond prices move in the opposite direction of interest rates. To illustrate this, consider a simple bond issued by a company, municipality, or the U.S. government.
Suppose it’s a $1,000 bond with a two-year maturity and a 10% coupon paid semi-annually. This means it pays 10% of the par value per year, split into $50 payments every six months.
If interest rates remain steady, an investor might pay $1,000 for the bond, expecting a fair return for the risk involved. However, if interest rates change, the bond’s value fluctuates accordingly.
Impact of Rising Interest Rates
When interest rates rise, new bonds offer higher yields. For example, if rates increase and similar-risk bonds now yield 15%, an investor would prefer those over the 10% bond.
To attract buyers, the price of the existing bond must drop to yield an equivalent 15% return. Thus, the bond trades at a discount.
Impact of Falling Interest Rates
Conversely, if interest rates fall and new bonds yield only 5%, the existing 10% bond becomes more attractive. Investors are willing to pay more than the original $1,000, making the bond trade at a premium.
Zero-Coupon Bond Example
A zero-coupon bond simplifies these calculations. Suppose a company issues a $1,000 bond maturing in two years, with no interim payments. If investors expect a 10% return, the price today (P) is calculated as:
P = 1000 / (1.10)^2 = $826
If interest rates rise to 15%, the bond price drops:
P = 1000 / (1.15)^2 = $756
If interest rates fall to 5%, the bond price increases:
P = 1000 / (1.05)^2 = $907
Conclusion
This inverse relationship between bond prices and interest rates makes sense: when investors demand a higher return, they pay less for existing bonds. When they accept a lower return, they pay more. Understanding this dynamic helps investors make informed decisions in the bond market.