You may have heard that bond prices rise when interest rates fall, and bond prices fall when interest rates rise. Why is this? A dollars and cents example offers the best explanation of the relationship between bond prices and interest rates.
Example Of How And Why Bond Prices Change When Interest Rates Rise
Facts
- You buy a bond for $1,000.
- It matures in four years (at which time you get back your $1,000 investment).
- Its coupon rate (interest rate) is 4%, so it pays 4% a year, or $40 a year.
Interest Rates Rise
- One year later interest rates rise to 5% and you decide to sell your bond because you need that $1,000.
- When you enter an order to sell, the order goes to the market, and potential buyers now compare your bond to other bond issues and offer a price.
- Since interest rates went up, a newly issued $1,000 bond which matures in three years (the time left before your bond matures) is paying 5% interest or $50 a year.
Market Adjustment To Bond Prices
- If an investor buys your bond for $1,000 they would receive $40 x 3, or $120 in interest over the remaining three years.
- If an investor buys a new bond for $1,000 they would receive $50 x 3, or $150 in interest over the remaining three years.
- There is no incentive to buy your bond at its face value of $1,000 since the investor would receive less interest than the newly issued bonds, thus the market adjusts the price of your bond to make it “equivalent.”
- In this set of circumstances you may receive an offer of about $970 for your bond. (When a bond sells for less than its maturity value it is said to trade at a discount.)
Bond Price Went Down To Adjust For Rise In Interest Rates
- An investor who bought your bond for $970 would now receive the $120 of interest, plus the additional $30 of principal when the bond matures.
- Because they were able to pay less for the bond, they would receive the same dollar amount of profit, over the same time frame, as if they bought a newly issued bond paying a higher interest rate.
Other Factors That Influence Bond Prices And Interest Rates
- This is a simplified example, as the final price of a bond depends on the credit quality, type of bond, maturity, and frequency of interest payments. In general, bonds with similar terms will adjust to interest rates in a like manner.
What Type Of Bonds Fare Well In A Rising Interest Rate Environment?
- Floating rate bonds funds and inflation-adjusted bond funds will fare well in a rising interest rate environment, because the interest payments on these types of bonds adjust.
