Bonds have an inverse relationship with interest rates. When the cost of borrowing rises (when interest rates rise) bond prices generally fall, and vice versa.

At first glance, the negative correlation between interest rates and bond prices seems somewhat illogical. However, on closer inspection, this is starting to make sense.

Key points to remember

  • Most bonds pay a fixed rate of interest which becomes more attractive if interest rates fall, causing demand and price for the bond to rise.
  • Conversely, if interest rates rise, investors will no longer prefer the lower fixed interest rate paid by a bond, causing its price to drop.
  • Zero coupon bonds provide a clear example of how this mechanism works in practice.

Bond price versus yield

Bond investors, like all investors, generally try to get the best possible return. To achieve this, they usually need to keep an eye on fluctuating borrowing costs.

A simple way to understand why bond prices move in the opposite direction of interest rates is to consider zero coupon bonds, which do not pay regular interest and instead derive their full value from the difference between the price of interest. purchase and face value paid. At maturity.

Zero coupon bonds are issued at a discount nominal value, with their returns based on the purchase price, the nominal value and the time remaining to maturity. However, zero coupon bonds also lock in the yield on the bond, which can be attractive to some investors.

Examples of zero coupon bonds

If a zero coupon bond trades at $ 950 and has a face value of $ 1,000 (paid at maturity in one year), the bond’s rate of return at the moment is 5.26%: 1000 – 950 950 x 100 = 5.26. In other words, for an individual to pay $ 950 for this bond, he must be satisfied to receive a return of 5.26%.

This satisfaction, of course, depends on what else is going on in the bond market. If current interest rates were to rise, while the newly issued bonds offered a 10% yield, then the 5.26% zero coupon bond would be much less attractive. Who wants a 5.26% return when they can get 10%?

To attract demand, the price of the pre-existing zero coupon bond would have to drop enough to match the same return produced by the going interest rates. In this case, the price of the bond would drop from $ 950 (which gives a yield of 5.26%) to around $ 909.09 (which gives a yield of 10%).

Now that we have an idea of ​​how the price of a bond moves with changes in interest rates, it’s easy to see why the price of a bond would rise if prevailing interest rates were to rise. lower. If rates were to drop to 3%, our zero coupon bond, with its 5.26% yield, would suddenly become very attractive. More people would buy the bond, which would push the price up until the bond yield met the going rate of 3%. In this case, the bond’s price would increase to around $ 970.87.

Given this price increase, you can see why bondholders, investors who sell their bonds, are benefiting from lower going interest rates. These examples also show how a bond’s coupon rate and therefore its market price are directly affected by national interest rates. To have a chance of attracting investors, newly issued bonds tend to have coupon rates that meet or exceed the current national interest rate.

Bond prices and Fed

When people refer to the “national interest rate” or “the Fed,” they are most often referring to the federal funds rate set by the Federal Open Market Committee (FOMC). This is the interest rate charged on the interbank transfer of funds held by the Federal Reserve (Fed) and is widely used as a benchmark for interest rates on all kinds of investments and debt securities.sese

The Fed’s policy initiatives have a huge effect on bond prices. For example, when the Fed raised interest rates by a quarter of a percentage point in March 2017, the bond market fell. The yield on 30-year treasury bills (T-bonds) fell to 3.02% from 3.14%, the yield on 10-year treasury bills (T-notes) fell to 2.4% from 2 , 53%, and the yield on two-year Treasuries’ yield fell from 1.35% to 1.27%.sesesese

The Fed raised interest rates four times in 2018. After the last hike of the year announced on December 20, 2018, the yield on 10-year T-notes fell from 2.79% to 2.69% .1 3.sese sese

The current COVID-19 pandemic has seen investors flee to the relative safety of government bonds, particularly U.S. Treasuries, causing yields to drop to historic lows. As of May 24, 2020, the 10-year T-note was yielding 0.64% and the 30-year T-bond was at 1.27%.

The sensitivity of a bond’s price to changes in interest rates is known as duration.

Zero coupon bond

Zero coupon bonds tend to be more volatile because they do not pay periodic interest during the life of the bond. At maturity, a zero coupon bondholder receives the face value of the bond. Thus, the value of these debt securities increases as they mature.

Zero coupon bonds also have unique tax implications, which investors should understand before investing in them. Even though no periodic interest payments are made on a zero coupon bond, the accumulated annual return is considered income, which is taxed as interest. The bond is expected to increase in value as it nears maturity, and this gain is not considered to be a gain, which would be taxed at the capital gains rate, but rather as a capital gain. returned.

In other words, taxes must be paid on these bonds every year, even if the investor does not receive any money before the bond’s maturity date. This can be a burden for some investors. However, there are ways to limit these tax consequences.


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