Understanding Bond Prices and Interest Rates
Bonds provide an element of stability that offsets some of the
volatility of stocks. However, they are vulnerable to economic changes
that can undermine their value.
The biggest economic threat to bonds is rising interest rates. If you
own a bond and interest rates go up, the value of your bond on the
open market, with few exceptions, will go down.
Of course, if you plan to hold the bond to maturity the value of your
bond doesnt change because interest rates change. Youll still get the
amount promise when you bought the bond, all other things being equal.
However, if you plan to own bonds for investment purposes - that is
you buy and sell bonds as you would stocks - then interest rates are
very important.
Bond Prices
Bond prices move inversely to interest rates. When interest rates go
up, bond prices go down and when interest rates go down, bond prices
go up. Remember, were talking about previously issued bonds trading on
the open market.
The inverse relationship is easy to see with this simple illustration.
A bond is issued for $10,000 for five years with a 5% coupon or
interest rate, paid every six months. Then interest rates rise to 6%.
If you want to sell this bond, who would buy it when it is paying 1%
below market rates (5% vs. 6%)? You have to sweeten the deal so the
buyer gets a market rate for the bond.
You cant change the interest rate on the bond. Thats fixed at 5%. You
can, however change the price you will take for the bond.
The annual payment of $500 ($10,000 x 5%) must equal a 6% payment.
Doing the math, you discover that the face value of the bond must be
discounted to $8,333 so that the $500 fixed payment equals a 6% yield
on the buyers investment ($8,333 x 6% = $500).
If interest rates went down instead of up, you could then sell your
bond at a premium over face value because the fixed interest rate
would be higher than the market rate.
Illustration
PLEASE NOTE: This is just an example to illustrate the relationship
between interest rates and bond prices. It does not represent an
actual computation. To do this calculation correctly would require a
more complicated process and the answer would be different. However,
the seller would still have to discount the face value of the bond to
compensate for the interest rate difference.
As I noted above, none of this matters if you plan to hold the bond to
maturity. Changing interest rates have no effect on existing bonds
unless you plan to buy or sell them in the open market.
Conclusion
Because of the interest rate risk, bonds with longer terms are more
risky than bonds with shorter terms. If you plan to trade bonds, be
sure you understand the interest rate risks involved and how holding
long-term bonds increases that risk.
