Interest rates and bond prices
When you buy a bond, either directly or through a mutual fund, you're lending money to the bond's issuer, who promises to pay you back the principal (or par value) when the loan is due (the bond's maturity date). In the meantime, the issuer also promises to pay you periodic interest payments to compensate you for the use of your money. The rate at which the issuer pays you — the bond's stated interest rate or coupon rate — is generally fixed at issuance.
An inverse relationship
When new bonds are issued, they typically carry coupon rates at or close to the prevailing market interest rate. Interest rates and bond prices have an inverse relationship; so when one goes up, the other goes down. The question is, how does the prevailing market interest rate affect the value of a bond you already own or a bond you want to buy from or sell to someone else? The answer lies in the concept of opportunity cost.
Investors look to compare the returns on their current investments to what they could get elsewhere in the market. As market interest rates change, a bond's coupon rate — which is fixed — becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself.
When interest rates go up, bond prices go down
A hypothetical example: The ABC Company offers a new issue of bonds carrying a 7% coupon on a $1,000 face value and a 10-year maturity. This means it would pay $70 a year in returns. After evaluating various investment alternatives, you decide to purchase the bond at its par value of $1,000.
- If interest rates go up: Let's suppose that later that year, interest rates in general go up. If new bonds that cost $1,000 are paying an 8% coupon — or $80 a year in interest — buyers will be reluctant to pay the $1,000 face value for your 7% ABC Company bond. In order to sell, you'd have to offer your bond at a lower price — a discount — that would enable it to generate approximately 8% to the new owner. In this case, that would mean a price of about $875.
- If interest rates fall: If rates dropped to below your original coupon rate of 7%, the bond would be worth more than $1,000. It would be priced at a premium, since it would be carrying a higher interest rate than what was currently available on the market.
Of course, many other factors go into determining the attractiveness of a particular bond, such as the length of time until the bond matures, whether or not its interest is taxable, the creditworthiness of its issuer, the likelihood that the issuer will pay off debt early, and more. Investors should be aware that interest rates vary virtually every day, and the movement of bond prices and bond yields are simply a reaction to that change.