When most people think about financial markets being like a roller coaster, they probably have the stock market in mind. But the bond market also has its ups and downs, even if they’re rarely as pronounced as the swings in equity prices.
Indeed, this year has seen two significant trends in bond prices: sharply higher in the first few months, and then sharply lower more recently.
In this post, we want to do two things: first, explain in a general sense how bond prices move in relation to interest rates. And second, we’ll take a look at how different kinds of bonds are affected to varying degrees when interest rates change.
The Relationship Between Bond Prices and Interest Rates
Let’s say you own a 5-year government bond that pays 3.00% interest per year. After purchasing the bond, interest rates on similar 5-year government bonds rise to 5.00%. How is this going to affect the price of your bond? To understand this, imagine that someone could purchase either the bond you own, which pays 3.00%, or the similar bonds now yielding 5.00%. Clearly they would prefer to purchase the 5% bonds. As a result, the 3.00% bond you own will fall in price until the ‘effective’ yield is more or less the same as the higher-yielding bonds.
The opposite is also true. If you own bonds that pay 3.00% interest (also known as the coupon rate), and interest rates on similar bonds fall, your bonds will be comparatively more attractive than the lower market rates. Thus, your bonds will rise in price because they offer a better return than newly issued bonds.
We can generalize the relationship between bond prices and interest rates as follows: when market interest rates fall, the prices of existing bonds rise. Conversely, when market interest rates rise, the prices of existing bonds fall in value. Thus, there is an inverse relationship between bond prices and interest rates.
How Different Bonds are Affected By Changes in Interest Rates
At MoneySense, Dan Bortolotti (of the blog Canadian Couch Potato) has a great chart that breaks down the differing degrees to which interest rate changes affect bond prices. To sum up, shorter term bonds (e.g. 1-year) will be much less affected by a rise or fall in market interest rates than longer term bonds (say, 5 or 10 years). Similarly, the higher the interest rate on an existing bond (i.e. the coupon), the less a change in interest rates will affect its price.
For example, if you own a bond that pays 5.00% interest, a 1.00% increase in market interest rates will not affect its price very much. But if you own a bond that pays 1.00% interest and market rates rise to 2.00%, the price of your bond would take a significant hit.
Think about it from the perspective of someone interested in buying your bonds off you. In the first case, they can buy your 5.00% bonds or bonds on the market which now yield 6.00%. Given a choice, they’ll only buy yours at a discount. But the discount won’t have to be huge in order for the ‘effective’ yield to reach 6.00%. By contrast, to entice someone to buy a bond yielding 1.00% when they can get 2.00% on the open market, they have to be offered the 1.00% bonds at a massive discount to face value.
The technical term for the factors that affect the sensitivity of a bond’s price to interest rates is known as duration. For those interested, you can read about duration at Morningstar’s website here.
Finally, as Dan Bortolotti explains, while higher interest rates do lower bond prices, the upside is that they allow individuals to re-invest the proceeds of maturing bonds at higher yields. Those holding decent amounts of cash can also use their liquidity for this purpose.
Flickr: Robert Fairchild