How Do Interest Rates in the Economy Affect the Price of a Corporate Bond?
A corporate bond is a marketable security that can be dramatically affected by market interest rates. Although the payments on most corporate bonds are fixed, in terms of interest rate and in the duration they will be paid, the price of a bond can be affected by a number of factors. Movements in market interest rates are one of the main influences on the volatility of a corporate bond price.
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Corporate Bond Characteristics
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A corporate bond is essentially a loan made to a company by an investor. In exchange for borrowing the money, the corporation agrees to pay the investor back at a predetermined date and to make regular fixed interest payments, usually twice per year.
Interest Rates and the Economy
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Economic interest rates are reflective of a number of factors, but generally speaking they are a reflection of the state of the economy. When economic activity is low, interest rates are usually low as well, while a booming economy with high inflation generally has correspondingly high interest rates.
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Bond Prices And Interest Rates
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Bond prices and interest rates have an inverse relationship. When interest rates rise, bond prices fall, and vice versa. The reason for this is simple supply and demand. If a company issues a bond paying 5 percent, and interest rates in the marketplace rise to 10 percent, investors will sell the 5 percent bonds to own the 10 percent bonds, as they are being paid twice as much interest. As a result, bond prices fall. When interest rates fall, say from 10 percent to 5 percent, more investors will buy the 10 percent bonds, driving the price up.
Allowance for Corporate Performance
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While changes in economic interest rates can dramatically affect the price of a corporate bond, the financial performance of the underlying company can serve to counteract that movement, at least to a degree. Bond prices are also affected by bond ratings, which are an indication of the financial strength of a company. If a corporation can have its rating upgraded due to more consistent financial performance, its bonds are considered less of a risk, and therefore its price tends to rise, in spite of current market interest rates.
Interest Rates And Maturities
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A bond with a short maturity date will not be as affected by moves in interest rates as a long-maturity bond. Bond prices on short-term bonds tend to creep toward par value, or the bond's redemption value, regardless of the movement of market interest rates, as investors will be receiving their money back sooner and have it available for reinvestment.
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References
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