Why do interest rates tend to have an inverse relationship with bond prices?

At first glance, the inverse relationship between interest rates and bond prices seems somewhat illogical, but upon closer examination, it makes sense. An easy way to grasp why bond prices move opposite to interest rates is to consider zero-coupon bonds, which don't pay coupons but derive their value from the difference between the purchase price and the par value paid at maturity. For instance, if a zero-coupon bond is trading at $950 and has a par value of $1,000 (paid at maturity in one year), the bond's rate of return at the present time is approximately 5.26% ((1000-950) / 950 = 5.26%). For a person to pay $950 for this bond, he or she must be happy with receiving a 5.26% return. But his or her satisfaction with this return depends on what else is happening in the bond market. Bond investors, like all investors, typically try to get the best return possible. If current interest rates were to rise, giving newly issued bonds a yield of 10%, then the zero-coupon bond yielding 5.26% would not only be less attractive, it wouldn't be in demand at all. Who wants a 5.26% yield when they can get 10%? To attract demand, the price of the pre-existing zero-coupon bond would have to decrease enough to match the same return yielded by prevailing interest rates. In this instance, the bond's price would drop from $950 (which gives a 5.26% yield) to $909 (which gives a 10% yield). Now that we have an idea of how a bond's price moves in relation to interest-rate changes, it's easy to see why a bond's price would increase if prevailing interest rates were to drop. If rates dropped to 3%, our zero-coupon bond - with its yield of 5.26% - would suddenly look very attractive. More people would buy the bond, which would push the price up until the bond's yield matched the prevailing 3% rate. In this instance, the price of the bond would increase to approximately $970. Given this increase in price, you can see why bond-holders (the investors selling their bonds) benefit from a decrease in prevailing interest rates.

Market Interest Rates and Bond Prices

Once a bond is issued the issuing corporation must pay to the bondholders the bonds stated interest for the life of the bond. While the bonds stated interest rate will not change, the market interest rate will be constantly changing due to global events, perceptions about inflation, and many other factors which occur both inside and outside of the corporation. The following terms are often used to mean market interest rate: effective interest rate yield to maturity discount rate desired rate

When Market Interest Rates Increase Market interest rates are likely to increase when bond investors believe that inflation will occur. As a result, bond investors will demand to earn higher interest rates. The investors fear that when their bond investment matures, they will be repaid with dollars of significantly less purchasing power. Lets examine the effects of higher market interest rates on an existing bond by first assuming that a corporation issued a 9% $100,000 bond when the market interest rate was also 9%. Since the bond's stated interest rate of 9% was the same as the market interest rate of 9%, the bond should have sold for $100,000. Next, lets assume that after the bond had been sold to investors, the market interest rate increased to 10%. The issuing corporation is required to pay only $4,500 of interest every six months as promised in its bond agreement ($100,000 x 9% x 6/12) and the bondholder is required to accept $4,500 every six months. However, the market will demand that new bonds of $100,000 pay $5,000 every six months (market interest rate of 10% x $100,000 x 6/12 of a year). The existing bonds semiannual interest of $4,500 is $500 less than the interest required from a new bond. Obviously the existing bond paying 9% interest in a market that requires 10% will see its value decline.

An existing bonds market value will decrease when the market interest rates increase. The reason is that an existing bonds fixed interest payments are smaller than the interest payments now demanded by the market.

When Market Interest Rates Decrease Market interest rates are likely to decrease when there is a slowdown in economic activity. In other words, the loss of purchasing power due to inflation is reduced and therefore the risk of owning a bond is reduced. Lets examine the effect of a decrease in the market interest rates. First, lets assume that a corporation issued a 9% $100,000 bond when the market interest rate was also 9% and therefore the bond sold for its face value of $100,000.

Next, lets assume that after the bond had been sold to investors, the market interest rate decreased to 8%. The corporation must continue to pay $4,500 of interest every six months as promised in its bond agreement ($100,000 x 9% x 6/12) and the bondholder will receive $4,500 every six months. Since the market is now demanding only $4,000 every six months (market interest rate of 8% x $100,000 x 6/12 of a year) and the existing bond is paying $4,500, the existing bond will become more valuable. In other words, the additional $500 every six months for the life of the 9% bond will mean the bond will have a market value that is greater than $100,000.

An existing bonds market value will increase when the market interest rates decrease. An existing bond becomes more valuable because its fixed interest payments are larger than the interest payments currently demanded by the market.

Relationship Between Market Interest Rates and a Bonds Market Value As we had seen, the market value of an existing bond will move in the opposite direction of the change in market interest rates. When market interest rates increase, the market value of an existing bond decreases. When market interest rates decrease, the market value of an existing bond increases. The relationship between market interest rates and the market value of a bond is referred to as an inverse relationship. Perhaps you have heard or read financial news that stated Bond prices and bond yields move in opposite directions or Bond prices rallied, lowering their yield... or The rise in interest rates caused the price of bonds to fall.

If you were the treasurer of a large corporation and could predict interest rates, you would... Issue bonds prior to market interest rates increasing in order to lock-in smaller interest payments. If you were an investor and could predict interest rates, you would... Purchase bonds prior to market interest rates dropping . You would do this in order to receive the relatively high current interest amounts for the life of the bonds. (However, be aware that bonds are often callable by the issuer.) Sell bonds that you own before market interest rates rise . You would do this because you dont want to be locked-in to your bonds current interest amounts when higher rates and amounts will be available soon.

"How do bonds work? Why do bond prices rise as interest rates fall, and vice versa? Bonds are debt instruments that pay a fixed income over their life and then pay a principal to the bondholder upon their maturity. The typical bond has a principal of $1,000 and for the purpose of

answering your questions, that's what my example below will assume. When a $1,000 bond is first issued, it has a stated "coupon rate" of some fixed percentage that is usually close to prevailing interest rates in the marketplace at that time. Let's suppose a particular $1,000 bond carries a coupon rate of 5 percent. That means it will pay interest of $50 to the bondholder, most likely twice a year in payments of $25.00 each time. When the bond matures, it will pay the bondholder $1,000. During the life of the bond, market conditions are likely to change substantially (including such major factors as the state of the economy, people's confidence in investing, rates of return on competing investment opportunities, etc.). And of course, being a bondholder doesn't mean you have to buy and hold the bond for its entire life; in fact, most bondholders don't do that. They buy and sell bonds all the time. For the bond we're talking about in the above paragraph to remain attractive and competitive in the marketplace during its life, its rate of return must adjust upwards or downwards accordingly. The promise to pay $1,000 at maturity never changes. The $50 per year interest payment never changes. What does change is the bond's market price, which could go above or below the face value of $1,000.