The Relationship between Bond Prices and Interest Rates!

Have you ever wondered why news reporters on Bloomberg or CNBC talk about bond prices and interest rates in the same sentence? Believe me; they have a good reason to do so. Bond prices and interest rates are inversely related.

Understanding the Basic Structure of Bond

A bond has a face amount and a coupon rate. There are other factors to consider when purchasing a bond; however, we will limit this article to the above mentioned components of a bond.

A bond has a face amount or par value (i.e. $1,000). This represents the amount the issuer will pay the bondholder at maturity. If you attempt to purchase a $1,000 face amount bond in the market, the amount you pay for the bond will be determined by the prevailing interest rate, but this will be mentioned later.

The coupon rate or stated interest rate printed on a bond is worth mentioning. The coupon rate is the percentage of the bond’s face amount that is paid on an annual basis. Keep in mind, many bonds pay interest every six months after issuance; therefore, you would receive half of the coupon rate x the face amount or par value twice a year. For example, if you purchase a bond with a face amount of $1,000 and coupon rate of 6%, then you can expect to receive an interest payment of $30, twice a year.

Bond Prices and Interest Rates

 A bond's yield to maturity (interest) is not to be confused with the coupon rate. For our above mentioned example, from the previous paragraph, the bond will be held to maturity and is not susceptible to call risk, the ability of the bond issuer to buy back the bond prior to its maturity. In simple terms, we are concerned with the bond’s yield to maturity. How much interest will you earn from purchasing this bond?

In our example, if you purchase a bond with a face amount of $1,000 and coupon rate of 6%, it is likely that you will not pay $1,000 for the bond, depending on the interest rates available in the market. Bond prices are inversely rated to interest rates. As interest rates go up, prices of bonds prices go down, and vice versa. If the bond currently costs $900, this means interest rates of similar bonds [i] are above the 6% coupon rate. Otherwise, the price of the bond would be trading above the face amount or par value (in our example, $1,000), and this scenario indicates the interest rates of similar bonds are paying below the six percent coupon rate. But, in our example, the yield to maturity is the difference in the face amount and the amount you pay for a bond ($1000-$800) and the coupon rate ($30 x 2 payments per year).