What Effect Does Interest Rate Have on Bonds?
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Bond Prices are Affected by Multiple Interest Rate Influences
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Bond prices are greatly affected by variations in interest rates in two important ways. The longer the maturity of the bond the greater the amount of variation. The lower the credit rating the greater the amount of variation as interest rates move. Both of these concepts are grounded in two mathematical concepts. Bond prices move inversely with yields. As yields rise bond prices decline in value in order to price at a market yield. Since short term bonds are close to maturity their price need not decline very much in order to be at a market yield. Longer bonds are also affected but to achieve the market yield the bond must trade at substantially lower prices.
For example, a two-year bond bought with a 4 percent coupon at par later trades in a market where yields are at 5 percent. The bond must trade at $98 to achieve an equivalent yield. A 30-year bond with a 4 percent coupon must trade at $90.
Bond Prices are Affected by Call Feature
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Were interest rates to fall to the 3 percent level the short bond would be worth approximately $102 and the 30-year bond worth $110. It is strongly recommended that individual investors do not invest beyond the 10-year range. Investors in the 10-year range can gain approximately 85 percent of the maximum yield of a 30-year bond while putting only one-third as much capital at interest rate risk. In addition, the bond probably has a call feature. Call features are a losing proposition for bond holders as they are penalized if interest rates move lower but investors bear the full decline if interest rates rise. This is because a decline in rates allows the issuing authority to redeem the bonds early and in the lower interest rate environment reissue the bonds with a new and much lower interest coupon. There is no such interest rate protection for the buyer. Furthermore, the bond holder of a callable bond cannot profit if interest rates move lower because sellers are obligated to sell at the appropriate lower cost. The shorter call date is always the lower cost rather than the original stated maturity when bonds trade at a maturity.
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Credit Affects the Interest Rate of the Bond
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During times of economic duress in a recession lower quality bonds no longer trade just on the general level of interest rates but include an added risk premium because of default fears. As a result bonds of better quality do not vary as much in price over a typical interest rate cycle. During periods of high interest rates spreads between high quality and lesser quality credits narrow as the absolute level of interest rates is high. Astute traders constantly trade among different quality bonds in order to achieve capital gains from pricing discrepancies.
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