Why Do Bond Prices Decrease When Interest Rates Increase?
Bonds are marketable securities. This means they can be bought and sold on the secondary bond markets after they are sold by the issuer. Bond prices are determined in the market by an individual bond's credit rating, time to maturity and coupon rate.
Other People Are Reading
-
Function
-
Bonds are issued with a specific coupon rate and maturity date. The coupon rate is the rate of interest the bond will pay each year and the bond face amount will be returned to the bond holder on the maturity date. For example, if a $10,000 bond has a coupon rate of 6 percent, the bond holder will receive $600 every year in interest and the $10,000 when the bond matures.
Market Adjustments
-
Because the rate of interest a bond pays is fixed, the only way the market can adjust for changing interest rates is to move the market price. If the current market interest rate is 8 percent for bonds similar to the bond described above, an investor will not pay $10,000 and earn just 6 percent. If the bond has 10 years until it matures, an investor would pay about $8,600 for the $10,000 bond so her investment will earn the market rate of 8 percent.
-
Calculations
-
The bond market uses a calculation called yield to maturity--YTM--to determine the price of a bond based on the bonds coupon rate and the current market rate. The calculation takes into consideration the interest that will be paid, and the difference between the current bond price and the face amount that will be paid at maturity.
Features
-
Bonds that pay a lower coupon than the current market rate will sell for less than the face amount. These are called discount bonds. Bond can also sell at a premium to the face amount. As rates rise, the prices will decline to keep the coupon payout equivalent to current market rates. Longer-term bonds will decline more in value than short term bonds. Bond holders can choose to hold a bond until maturity and receive the full face amount.
-
References
- Photo Credit silver bevel symbol percentage image by PaulPaladin from Fotolia.com
