To succeed in investing, one of the most basic and fundamental concepts investors have to understand is the inverse relationship between bond prices and interest rates. This forms the base of many investing strategy assumptions and can help investors predict movements in price and yield within the bond market.
What is a bond?
A bond is debt instrument used to raise capital. It is a form of borrowing and bonds are sold by the government, states, cities, financial institutions and corporations. A bond is the promise to repay the principal with interest, or coupons, on a specific date of maturity.The price of a bond, therefore, is the amount an investor has to pay to buy a bond, regardless of whether this is above, below or at par value.
What are interest rates?
Interest rates are the cost of the use of money. It is the rate paid or received for a principal amount and is used by reserve banks the world over, such as the U.S. Federal Reserve Bank, as a tool for controlling fiscal policy. The Federal Reserve Bank can adjust the interest rates to suit the current economic climate. In recessions, a lower interest rate releases more credit into a downward trending economy, jump-starting consumer spending.
How do interest rates drive bond prices?
Interest rates and bond prices have an inverse relationships. When interest rates fall, bond prices rise and vice versa. The simplest example that illustrates this relationship is in the case of a zero-coupon bond, which do not pay out coupons but derives its value from the difference between purchase price and par value at maturity date.
For example, if a zero-coupon bond is priced at $95 and will pay out $100 in a year’s time, the bond’s rate of return is approximately 5.26% ((100-95)/95 = 0.00526). Investor seek the highest return on their investments, and would compare the rate of return on this bond to what else is happening in the markets. If prevailing interest rates at the time are higher than 5.26%, say 8%, there would be virtually no demand for the bond as investors seek better rates of return in other investments.
An interest rate of 8% would drive down the price of the bond to $92.60, which would give investors a rate of return of 8%, commiserate with the current interest rate. This situation would play out in reverse if interest rates were to fall, or be below the bond rate of return.
In summary, bond pricing is a complex procedure, but the relationship between bond prices and interest rates is clearly inverse and proven by historical market movements. With knowledge of this relationship, investors can react appropriately to interest rate changes, buying or selling bond investments in response to price movements.
Sources:
http://www.investorwords.com/521/bond.html
http://www.investorwords.com/2539/interest_rate.html
http://www.money.howstuffworks.com/fed-change-interest-rate.htm
http://www.wellsfargoadvantagefunds.com/wfweb/wf/education/choosing/bonds/rates.jsp