Bond Prices and Interest Rates

The price of high quality bonds is directly related to interest rates.  Investors that are looking to expand their portfolio of stocks to include bonds need to understand the relationship between bond prices and interest rates.

In this publication, we're going to attempt to explain the relationship between interest rates, coupon rates, bond prices, current yield, and bond yield.  As part of that explanation, we'll talk about the affect a bond's maturity date as well as credit rating can have on its market price.

Interest Rates and Bond Prices

While the price of junk bonds typically follow economic conditions, just like stocks; the price of investment quality bonds are usually linked to interest rates.  In fact, there is an inverse correlation between interest rates and bond prices.  That relationship can be further explained using two simple rules of thumb:

• When interest rates rise, the price of a bond will decline.
• When interest rates fall, the price of a bond will rise.

Later in this publication, we'll clarify why this relationship exists.

Primary and Secondary Bond Markets

There are really only two capital markets that deal with the issuance of bonds - primary and secondary markets.  The primary market is associated with the issuance of new bonds.  These can be companies or government agencies that are raising funds through the sale of bonds.  These bonds are usually purchased through securities dealers.

The secondary bond market is where issues are traded before they mature.  Except where noted, most of the relationships explained in this publication apply to the secondary bond market.

Coupon Rates, Bond Yields, and Interest Rates

When a bond is first issued, it will pay a fixed rate of interest until maturity.  That interest rate is referred to as the coupon rate.  The coupon rate of any bond is related to the credit risk of the issuer as well as the prevailing interest rate on the market when the bond was first issued.

Over time, interest rates will change but the coupon rate will stay the same, as will the payments to the bondholder.  If interest rates fall, new bond issues will offer the market a lower coupon rate.  The reverse is true if interest rates rise - coupon rates will increase.  Since the coupon rate is fixed, the price of bonds on the secondary market need to rise or fall to remain competitive with the primary market.

Let's see how the prices of bonds move with interest rates using some examples.

Bond Price Example 1 - Rising Interest Rates

In this first example, a $1,000 bond is issued with a coupon rate of 5%, resulting in a payment of $50 per year to the bondholder.  If interest rates increase to 7%, then the perceived, and actual, value of the bond will decrease.  An investor would never pay $1,000 for a bond with a coupon rate of 5% on the secondary market when new issues of similar quality are paying 7%.

Regardless of the prevailing interest rates, the coupon on this bond is fixed at 5%, and the holder will receive $50 per year.  In order to remain competitive with new issues, the bond would sell at a discount to its face value.  To provide a potential buyer with a 7% yield, the price of the bond would have to decrease to $50 / 0.07 or $714.29.

Bond Price Example 2 - Decreasing Interest Rates

In this second example, a $1,000 bond is issued with a coupon rate of 5%, resulting in a payment of $50 per year to the bondholder.  If interest rates decline to 3%, then the perceived, and actual, value of the bond will increase.  An investor would pay a premium for a $1,000 bond with a coupon rate of 5% on the secondary market when new issues of similar quality are paying 3%.

Here again, regardless of the prevailing interest rates, the coupon on this bond is fixed at 5%, and the holder will receive $50 per year.  In order to remain competitive with new issues, the bond would sell at a premium to its face value.  To provide a potential buyer with a 3% yield, the price of the bond would have to increase to $50 / 0.03 or $1,666.67.

Bond Yield and Prices

Buyers need to understand the bond's yield before purchasing the bond.  There is an inverse relationship between a bond's yield and its price.  As demonstrated in the examples provided above:

• When interest rates increase, the price of the bond will fall, and the bond's yield will increase to remain competitive with the prevailing interest rates.
• When interest rates are falling, the price of the bond will rise, and the bond's yield will decrease to remain competitive with prevailing interest rates.

Coupon Rates, Bond Yields, and Maturity Dates

Another factor that will influence the price of a bond is its maturity date.  That's because when a bond matures, the holder of the issue will receive a payment equal to the face value of the bond.  If the bond is selling at a premium to its face value, then the holder will receive less than the price paid for the bond.  If the bond is selling at a discount, then the holder will be paid more than the price they paid for the bond.  In other words, if the bond is selling at a discount or premium to its face value, then that difference in price will be another component of the bond's yield.

If the bond's maturity is in the distant future, this premium or discount will have less influence on the bond's yield then if the bond matured in the near term.  Once again, let's see through an example how the prices of bonds vary with maturities.

Bond Price Example 3 - Rising Interest Rates, Long and Short Maturity

In this third example, we're going back to our $1,000 bond issued with a coupon rate of 5% that pays the bondholder $50 per year.  Once again, interest rates have risen to 7%.  To provide a current yield of 7%, the price of the bond needs to drop to $714.29.

• If that bond matured in ten years, then it would also return to the holder $1,000 - $714.29 or $285.71 at maturity.  In this example, the bond's yield to maturity would be 9.56%.
• If that bond matured in thirty years, it would also return that same $285.71 at maturity, however, the bond's yield to maturity drops to 7.39%.

At a more practical level, investors will be more concerned about bond yield to maturity than current yield.  In the example above, a bond with 10 years to maturity and a coupon rate of 5% would be priced at $859 to produce a yield to maturity of 7%.  The same bond with thirty years to maturity would be priced at $751.

From this example, we can derive two more bond-pricing guidelines:

• When interest rates increase, the longer the bond's maturity, the larger the discount saved.  Bonds of shorter maturity will have smaller discounts.
• When interest rates decrease, the longer the bond's maturity, the larger the premium paid.  Bonds of shorter maturity will have smaller premiums.

Note - all of the above examples in this article were produced using our bond yield calculator.

Credit Ratings and Bond Prices

All bonds are assigned ratings that qualify the quality of the issue.  Ratings are standardized and assigned to bonds by credit rating agencies.  The market relies on the bond ratings provided by three agencies - Moody's, Standard and Poor's, and Fitch Ratings.  The system used by each company to indicate the quality of a government or company's bond offering appears in the table below.

Bond Rating Grades

Note to Bond Rating Table:  Moody's uses a modifier of 1, 2, or 3 to show relative standing in a category.  Standard and Poor's and Fitch Ratings use a modifier of plus or minus.

There are roughly ten different credit ratings, or grades, that each agency publishes.  The ratings range from Investment Grade to In Default.  In addition, each company offers refinements, or additional granularity, to these codes such as a plus or minus sign to indicate direction or relative standing within a particular rating category.

When you hear a report about a company's bond rating, you are really hearing information about the credit quality of the issuer.  When a company has a poor bond rating, they present a credit risk to the bond market, banks, and / or investors.

As an investor, you can choose to lend companies money by purchasing their bonds.  As a creditor of that same company, you are assuming a risk of repayment.  As is the case with most investments, there is no free ride with bonds.  Issues providing above average returns to the investor, such as junk bonds, will carry above average risk of default.  Bonds of higher quality will return less to the investor, but the risk of default is lower too.

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