The cost or value of the future cash stream generated by a bond is known as bond value or bond price. Not that you are not familiar with but bond values play a major role in bond investments and affect the investors on a certain level. In here, we are going to discuss, how interest rates affect the bond values?
If you don’t know but bond prices and interest rates tend to have an opposite relationship with each other. That means when interest rates go up the bond prices go down and vice versa. So, let’s consider one-by-one.
When Rates Rise
Let’s assume there is an investor A, who bought a 5 percent annual coupon rate and a par value of Rs. 10,00,000 on a 10-year corporate bond from the issuer of the bond, he will receive the bond’s interest rate as income over the lifetime of the bond and will receive the principal amount of Rs. 10,00,000 at maturity. So, the annual income would be Rs. 50,000, Rs. 10,00,000 invested, and Rs. 10,00,000 returned at maturity.
If the interest rate goes up to 6 percent then the 5 percent of the bond will be less valuable due to what an investor expects when to buy a bond. If investor B wants to buy a bond then he can now buy at 6 percent annual coupon rate from the issuer on the principal amount of Rs. 10,00,000 on a 10-year corporate bond. Now the annual income he would get is Rs. 60,000.
In this case, investor B would never go for buying the same from investor A with interest rate of 5 percent since he is already getting 6 percent from the issuer.
Now that investor B is earning Rs. 10,000 more than investor A, if investor A plans to sell his bond, then he may need to discount his bond at least by Rs. 10,000.
When Rates Fall
If the rates drop to 4 percent then the investor B would likely to pay more than Rs. 10,000 to investor A or 10-year corporate bond of 5 percent instead of buying directly from the issuer.
This shows that greater the change in interest rates, the greater the change in bond values. On top of that the longer maturity period also impact on the bond values.
What if the Interest Rate Changed in Middle?
If the interest rate goes up to 6 percent in the second year, for investor A of his 10-year bond, the possibility of bond prices t go down would be even more. And it would be more than the same change in a ninth year instead of the second year. It is because when the interest rate changed in the second year, there are still eight years left of uncertainty and possible price change.
Hope, now you’ve got the clear idea on the inverse relationship between bond prices and interest rates. Understanding this will allow you to make smart investment decisions regarding your investments.
These interest rates are heavily influenced by the interest rate decisions taken by the authority like Reserve Bank of India (RBI) which also need to look upon.