Investing Classroom: Bond Market Interest Rates

Bonds are very sensitive to changes in interest rates. If you plan to buy and sell bonds on the secondary market, you will need to watch interest rates very carefully. This is because interest rates, more than anything else, determine the prices of bonds. As an educated investor, you need to understand bond market interest rates and how they affect bonds prices of both original issue and secondary market bonds.

Interest rates and bond pricing
When a bond is issued, it pays a fixed rate of interest called a coupon rate until it matures. This rate is related to the current prevailing interest rates and the perceived risk of the issuer. When you sell the bond on the secondary market before it matures, the value of the bond, not the coupon, will be affected by the then-current market interest rates and the length of time to maturity.

Interest rate risk is the risk that changing interest rates will affect bond prices. When current interest rates are greater than a bond's coupon rate, the bond will sell below its face value at a discount. When interest rates are less than the coupon rate, the bond can be sold at a premium--higher than the face value. A bond's interest rate is related to the current prevailing interest rates and the perceived risk of the issuer.

Let's say you have a 10-year, £500 bond with a coupon rate of 5%. If interest rates go up, new bond issues might have coupon rates of 6%. This means an investor can earn more interest from buying a new bond instead of yours. This reduces your bond's value, causing you to sell it at a discounted price.

If interest rates go down, and the coupon rate of new issues falls to 4%, your bond becomes more valuable, because investors can earn more interest from buying your bond than a new issue. They may be willing to pay more than £500 to earn the better interest rate, allowing you to sell it for a premium.

Bond yields and market pricing
The amount of return a bond earns over time is known as its yield. A bond's yield is its annual interest rate (coupon) divided by its current market price.

There is an inverse relationship between a bond's yield and its price. When interest rates rise, bond prices fall (they are sold at a discount from their face value) and their yields rise to be consistent with current market conditions. The buyer's yield will be higher than the seller's was because the buyer paid less for the bond, yet receives the same coupon payments while the redemption price is higher than the purchase price. For example, suppose interest rates have risen from 5% to 6.25%, meaning bond prices have fallen. You can now buy a bond with a face value of £1,000 and a coupon rate of 5% (£50 per year) for £800, making your bond's yield consistent with current interest rates (50/800 x 100 = 6.25%). The reverse is also true.

When interest rates fall, bond prices rise and their yields fall to be consistent with current rates. When interest rates fall, bond prices rise and their yields fall to be consistent with current rates. Investors selling these bonds can make a profit. For example, the price of the £1,000 bond with a 5% coupon now rises to £1,100 to give it a yield equivalent to current market conditions of 4.6% (50/1,100 x 100). Buyers may be willing to pay the extra £100 to take advantage of the higher income generated by the coupons (£50 as compared to £46 from new issues), while sellers are looking to take advantage of the opportunity to make a profit. At maturity, the buyer will receive less money (£1,000) than was paid for the bond (£1,100). This could be claimed as a capital loss, which may provide a valuable tax strategy for the investor.

There is also an opposite relationship between the credit rating of a bond and its yield. The lower the credit rating, the more credit risk that a bond issuer could default on the payment of interest or principal on the bond. The investor requires a higher return on his/her money in exchange for accepting more risk. For this reason, a bond with a low credit rating will demonstrate a higher yield than a bond with a high credit rating. Correspondingly, a changing credit rating for a particular bond issue will affect its yield in the opposite direction.

Bond maturities and interest rates
Changing interest rates affect bonds with varying maturities differently. Bond prices change with changing interest rates, so the effective yield of a previously issued bond will be more in line with that of current issues. Bonds sell for a premium in a declining interest rate environment and sell at a discount in a rising interest rate environment. The redemption value at maturity is less for the premium bond and is more for the discount bond. The difference between the purchase price and the redemption price is a component of the bond's yield. The further a bond is from maturity, the greater will be the difference between the purchase price and the redemption value at maturity. Let's look at an example.

Bonds sell for a premium in a declining interest rate environment and sell at a discount in a rising interest rate environment.

If a bond with a 5% coupon and a 10-year maturity is sold on the secondary market today while newly issued 10-year bonds have a 6% coupon, then the 5% bond will sell for £92.56 (par value £100). The £5 coupon payment (5.4% of the £92.56 selling price) plus the additional £7.44 received at maturity (£100 par value - £92.56 = £7.44) produces a 6% yield-to-maturity. Now what happens if this 5% bond matured in 20 years? It would sell at a discounted price of £88.44 to produce a 6% yield-to-maturity. So, when interest rates rise, the longer a bond's maturity, the more a bond seller will discount its price. The shorter the bond's maturity, the smaller the discount.

This also means that when interest rates fall and bonds are sold at a premium, bonds with shorter maturities will have smaller premiums than bonds with longer maturities.

Duration, interest, and maturity
Investors use duration to predict bond price changes. Duration is a measure of a bond's interest rate risk. Duration is calculated from the weighted average of a bond's coupon rates, principal, and time until these rates are paid. It is expressed as years from a bond's purchase date. As the value of a bond changes, so does its duration.

When interest rates change, the price of a bond will change by a corresponding amount related to its duration. For example, if a bond's duration is five years and interest rates fall 1%, you can expect the bond's prices to rise by approximately 5%. Therefore, if you expect interest rates to rise, you want to invest in bonds with lower durations. Low duration means less volatility or price risk.

In general, the shorter a bond's maturity, the less its duration. Bonds with higher yields also have lower durations. A zero-coupon bond's duration is the time to its maturity.

Watch bond interest rates carefully
Current interest rates are the key determinant of bond prices on the secondary market. Lower interest rates can mean higher bond prices on the secondary market. Prudent investors buy and sell bonds based on current interest rates, bond coupon rates, and maturity. As a savvy investor, you need to understand how changes to interest rates affect bond prices. You also need to understand the relationships of bond yields, maturities, and durations to interest rates.

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