Interest rates and bond prices tend to have an opposite relationship with each other. Imagine a seesaw with bond prices at one end, and interest rates at the other. When interest rates go up, bond prices go down and vice versa.
How Bonds Work
Bonds are investments which allow governments and corporations to borrow money from investors for a specific amount of time, at a variable or fixed interest rate. With most types of bonds, the investor receives income based on the amount invested and the interest rate. For example, a 4% bond purchased for $10,000 will generate $400 per year for the investor. To understand why interest rates and bond prices work in opposite directions, think about real-life investors.
Example 1: When Rates Rise
If investor A buys a 4% 10-year corporate bond from the issuer of the bond, she will receive the bond’s interest rate as income over the lifetime of the bond, and will receive her principal back when the bond matures. That translates to $10,000 invested, $400 annual income and $10,000 returned at maturity. (For related reading, see: Interest Rates and Your Bond Investments.)
If interest rates go up to 5%, the 4% bond becomes less valuable due to what an investor expects when they buy a bond. If investor B wants to buy a corporate bond, he can now buy a 5% 10-year corporate bond directly from the issuer for $10,000, or he can buy investor A’s bond from her in the marketplace.
If he buys a 5% 10-year bond from the issuer for $10,000, he will receive $500 annual income. He would have no reason to pay $10,000 to buy investor A’s 4% bond, since her bond generates $100 less income each year.
If investor A wants to sell her bond, she will need to sell it at a discount in the marketplace. Investor B expects to make $5,000 on his bond ($500 x 10 years = $5,000 total income). Since investor A will only make $4,000 on her bond ($400 x 10 years), she may need to discount her bond by as much as $1,000 to make it enticing for investor B to buy it from her.
Example 2: When Rates Fall
The opposite is true if interest rates drop to 3%. If investor B wants to buy a 10-year corporate bond after the rate falls to 3%, he would be willing to pay more than $10,000 to buy investor A’s 4% bond from her, instead of buying the 3% bond directly from the issuer.
The greater the change in interest rates, the greater the change in bond values. Additionally, longer maturity bonds can experience bigger shifts in prices.
Let’s return to investor A. If the interest rate goes up to 5% in year two of her 10-year bond, the bond price will likely drop more than it would if the rate goes up to 5% in year nine. The reason is that in year two, the bond still has eight years of uncertainty and possible price change. However, in year nine, the bond is within one year of maturity, which means that the par value - or the face value of the bond - will be paid back to the owner of the bond on the maturity date.
The Bottom Line
Interest rates and bond prices have an inverse relationship with each other. Understanding why and how can help you make better investing decisions. (For related reading, see: Bond Basics: Bond Prices and Yield to Maturity.)
Disclosure: Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. An issuer may default on payment of the principal or interest of a bond. Bonds are also subject to other types of risks such as call, credit, liquidity, interest rate, and general market risks. Securities and advisory services offered through FSC Securities Corporation, member FINRA/SIPC. Insurance services offered through Brennan Financial Services, which is not registered as a broker-dealer or investment advisor. Financial planning services offered through DBT Wealth Consultants, LLC, a registered investment advisor. Listed entities are not affiliated with FSC Securities Corporation. 15455 Dallas Parkway, Suite 1325, Addison, Texas, 75001, (972)-980-7526.