How Interest Rates affect Bond Prices

Bonds are low-risk financial products that bring steady returns. If you are looking to invest in bonds, know that bond prices move differently from stock prices. Bond prices are inversely related to the interest rates on lending. When the interest rates rise, bond prices fall. When the rates fall, bond prices move upwards again.

Why does this happen? To understand, let’s look closely at the relationship between bond prices and interest rates.

What is a bond?

Government bodies and corporate organisations issue bonds to raise funds. When you invest in bond, you provide a loan to the issuer of the bond. They come with a maturity date. Every year till maturity, the bond issuer pays you interest in the form of coupon payments. The coupon is paid twice a year throughout the term. On maturity, the issuer repays the face value of the bond. If you stay invested until the bond matures, you get back the principal along with interest payments.

What if you wish to exit the investment before the maturity date? You can sell it on the secondary market at the prevailing market price. It is here that the inverse relationship between interest rates and bond prices becomes significant.

Just keep in mind that the bond valuation and its coupon rate remain unchanged regardless of the market price.

Relation between interest rate and bond price

Why do bond prices move in the opposite direction to the interest rates? Let’s consider two scenarios here—one where the interest rates rise and another where the rates fall.

What happens when interest rates rise?

Say, you already hold a bond with a face value of Rs 1,000 and a coupon rate of 5%. When the interest rates for lending are raised, government bodies and corporates will issue new bonds with higher coupon rates.

Let’s assume the new bonds have a coupon rate of 6%. Investors will obviously prefer bonds that have a higher rate. So, demand for your 5% rate bond will drop. As a result, your bond’s market price will keep falling until its relative return goes up to 6%.

In this scenario, if you wish to sell the bond, you will have to sell it at a discount. To provide a 6% rate (at par with the new bond), you will have to sell your bond at Rs 750. Although this may not be a desirable transaction for you as the bondholder, investors who buy the bond at a discounted price could earn a higher return overall.

What happens when interest rates fall?

Let's suppose that the interest rates decline. Any new bonds that are issued now will have a lower coupon rate—say, 4%. That means your 5% bond will seem more attractive to new investors, though bondholders may be less willing to part with the bond.

Demand for your 5% bond will start to rise, and so will its market price. The market price will keep growing until the effective return on your bond stands at 4%. That would happen at around Rs 1,250.

In this scenario, you may prefer to hold on to the bond since its return rate has improved. But you could also sell the bond on the secondary market at a significant premium.

Difference between bond yield and coupon rate

As a bond investor, you should also know the distinction between bond yield and coupon rate. The coupon rate is the fixed interest income you earn on a bond’s face value each year. The bond’s yield to maturity, on the other hand, includes not only the coupon payment but also other estimated returns assuming that the bond is held till maturity.

For a Rs 1,000 bond with a yearly coupon payment of Rs 40, the coupon rate is 4%. At face value, both the coupon rate and the yield, are equal. But suppose you sell the bond at a premium of Rs 100. Now, the yield changes to Rs 40/Rs 1,100 * 100 = 3.6%. If you sell the same bond at a discount of Rs 20, the yield changes to Rs 40/Rs 980 * 100 = 4.08%.

The yield to maturity encompasses both the coupon rate and any returns resulting from changes in the bond's market price. That is why bond investors pay more attention to the bond yield while investing.

Last but not least

Bond pricing can be complicated. So, do yourself a favour and open a Demat account and a trading account with a trusted broker like ICICI Direct. You can then access their in-depth research and market outlooks on the bond market. Use these to chalk out an effective investment strategy that works for you!

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