How Do Interest Rates Affect Bonds?

Bonds and Interest Rates

People buy bonds because they have fixed interest rates (except in a few special cases), and they are considered guaranteed investments. Therefore, the interest rate or coupon rate on a bond does not change throughout the lifetime of the bond. Because bonds have fixed interest rates, your only likely way to sell them off is to reduce their price.

A Practical Example

Going back to our initial example, if you buy a five-year bond that has a par value of $1,000 at a 5 percent interest rate, the annual interest payment would be $50. If, when you decide to sell the bond, interest rates have risen to 6.5 percent, anyone who wants to buy your bond will expect to receive interest payments at the ongoing market rate of 6.5 percent. But your bond can only pay out $50 a year. Since interest rates are fixed, the only way you can ensure that your buyer gets a 6.5-percent return is to reduce the price to $769.23 ($50 divided by 6.5 percent). Because you paid $800 for this bond, so you are selling at a loss. Changes in interest rates do not matter much when buying bonds that you intend to keep to maturity, but the risks are more pronounced in short-term bond trading. You need to be aware of these risks in order to minimize your losses.

Resources

• The Skinny on Bonds
• The Motley Fool Bond Center