Example Of How And Why Bond Prices Change When Interest Rates Rise
You buy a bond for $1,000.
It matures in four years (at which time you get back your $1,000 investment).
Its coupon rate (interest rate) is 4%, so it pays 4% a year, or $40 a year.
Interest Rates Rise
One year later interest rates rise to 5% and you decide to sell your bond because you need that $1,000.
When you enter an order to sell, the order goes to the market, and potential buyers now compare your bond to other bond issues and offer a price.
Since interest rates went up, a newly issued $1,000 bond which matures in three years (the time left before your bond matures) is paying 5% interest or $50 a year.
Market Adjustment To Bond Prices
If an investor buys your bond for $1,000 they would receive $40 x 3, or $120 in interest over the remaining three years.
If an investor buys a new bond for $1,000 they would receive $50 x 3, or $150 in interest over the remaining three years.
There is no incentive to buy your bond at its face value of $1,000 since the investor would receive less interest than the newly issued bonds, thus the market adjusts the price of your bond to make it “equivalent.”
In this set of circumstances you may receive an offer of about $970 for your bond. (When a bond sells for less than its maturity value it is said to trade at a discount.)
Bond Price Went Down To Adjust For Rise In Interest Rates
An investor who bought your bond for $970 would now receive the $120 of interest, plus the additional $30 of principal when the bond matures.
Because they were able to pay less for the bond, they would receive the same dollar amount of profit, over the same time frame, as if they bought a newly issued bond paying a higher interest rate.
Other Factors That Influence Bond Prices And Interest Rates
This is a simplified example, as the final price of a bond depends on the credit quality, type of bond, maturity, and frequency of interest payments. In general, bonds with similar terms will adjust to interest rates in a like manner.
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