The relationship between interest rates and bond prices

If you’ve paid attention to financial news, you would have read/seen headlines such as:

“Interest rates up, bonds prices fall.”

The relationship between interest rates and bond prices is an inverse one. When interest rates increase, bond prices fall and when interest rates fall, bond prices increase. But why is that? It’s kind of like when the latest phone model launches in the market. It has all these new features that an older phone in the same series does not have. So, anyone who is looking to buy a phone will consider the newer model with the newer features even if the price of this new model is higher than that of the older model. This is because the benefits that the phone user will derive from using the new model will be more than the old phone. In the case of bonds, these benefits are the returns or the interest. Let’s explore this further.

What is the relationship between bond prices and interest rates?

Say you invested in a bond that has an interest rate of 5%. After four months, the interest rate levels in the economy increase and now bonds of the same credit quality and type are being issued at an interest rate of 7%. In such a case, when investors are looking to invest in bonds, they will naturally want to opt for the newly issued bonds with a higher bond interest rate. This is because if they were to invest in the bond you hold at a 5% interest rate, they would have to bear the opportunity cost of the additional 2% bond interest rate that they could have earned.

No investor likes to bear such an opportunity cost and earn low returns. Hence, the demand for bonds with the lower interest rate drops in the stock market while the demand for the 7% interest rate bonds increases. A decline in demand automatically leads to a decline in the value of bonds in the market. The relationship between interest rates and bond prices is hence like a seesaw. The reverse, too, is true. If the interest rates in the economy were to fall, the newly issued bonds would have a lower interest rate as well. In this case, the demand for previously issued bonds would increase because they are the ones with the higher interest rate. Hence, the value of those bonds would increase. In this way, bond prices and bond interest rates move in opposite directions.

What does the relationship between bonds and interest rates mean for you?

The sensitivity of bond prices to changes in interest rates is called interest rate risk. Interest rate risk is one of the primary risks of investing in bonds. This is because fixed interest rate bonds maintain the same interest rate throughout the maturity period of the bond. When interest rates rise in the market, your bond investments don’t reflect that, and you miss out on the opportunity to earn more interest. This risk is higher for bonds with long-term maturities.

To hedge interest rate risk, it’s recommended to build a diversified bond portfolio with bonds of different maturity periods. It’s also helpful to know what your financial goal is when investing in bonds so you can make strategic investment decisions accordingly. For instance, if you want to earn regular interest and have a passive source of income, then holding the bond until maturity would work and then the price fluctuations of the bond in the secondary market wouldn’t be quite as relevant.

Interested in bonds? You can check them out here if you want. 

*Investment in securities market, bonds and Mutual Fund investments are subject to market risks, read all product/scheme related documents carefully.

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