Bond prices rise when interest fall. Conversely, bond prices fall when interest rates rise. People are often puzzled by this relationship, and it’s understandable why the confusion exists. This article is going to help clarify it once and for all.
You have to think about it in terms of what kind of rate can you get in the current market? Always fall back on that when you get confused. If you get nothing else out of this article, let it be that. I will show you how that helps. Always ask what rate can I get right now in the open market?
Let’s start with a scenario. Suppose interest rates are 5% and you are looking to buy 5% coupon bond with a par value of 100. Forgetting any kind of fees to purchase the bond, you can reasonably expect the price of the bond to be $100. What is the current interest rate? 5%
You purchase the bond and pay $100. For the sake of argument, assume the bond matures in 5 years. Maturity does factor into bond pricing, but for this discussion we will pretend as though it doesn’t.
Suppose after one month, interest rates rise to 6%. How much can you get for the 5% bond that you hold? There is a calculation to help you figure it out. However, from a high level, should you expect the price to be $100? Or, will it be greater than $100 or less than $100?
Here is where you have to ask what the current market rate is? In our current scenario, it’s 6%. This means that someone wishing to buy a 6% bond with a par value of 100 will pay $100 (ignoring maturity date).
A bond paying 6% is more attractive to investors than one paying 5%. Therefore, why would someone pay you $100 for your bond that pays 5%, when they can purchase a 6% in the current market for $100? Your bond needs to be discounted. You would use a formula to figure out exactly how much your bond will be discounted.
Let’s consider the opposite scenario where interest rates drop to 4%. In this case, 4% is less attractive to investors. Your 5% bond is going to be more attractive and people will be willing to pay a premium. If someone can get a 4% bond for $100, they must be willing to pay more for a 5% bond. Once again, the actual price is based on a formula that you can find all over the web or you can use a spreadsheet to easily find the price.
As you can see, when you compare the price of your bond to the current price, you just ask yourself would people be willing to pay me more for the bond? If your bond is more attractive the answer is yes. If it is not, then the price would be discounted.
A true discussion on bond pricing must account for the maturity of the bond. For instance, you cannot expect a bond paying 5% that matures in one year to have the same price as a bond paying 5% that matures in five years. All things being equal, the 5-year maturity is going to have more risk. Part of that risk is default is the lender defaulting on the bond. Another risk is the opportunity cost of tying your money up in one bond while interest rates are higher.
All of these dynamics is the reason why bond pricing is more complicated than people realize. It is beyond the scope of this article. However, this article should give you a better understanding of why bond prices fall when interest rates go up and vice versa.
You should not misconstrue the information here as investment advice. It is for informational purposes only and you should consult a qualified professional for any advice on your money.