Why Do Bond Prices Go Down When Interest Rates Rise?


Example Of How And Why Bond Prices Change When Interest Rates Rise

Facts

  • 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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