why do bond prices decline when interest rates increase?

Answer 1

Suppose you own a bond with a face value of $1,000 that is earning interest of 5% until 12/31/2006. In other words your bond is earning $50 per year.

If 5% is the rate that similar bonds being issued today are paying then your bond could be sold for $1,000.

But suppose 10-year bonds similar to yours are being issued at 6% now. In other words an investor can earn $60 per year on a $1,000 investment. Why would they choose to earn $50 on a $1,000 investement when they can earn $60? They wouldn't. But they would be willing to pay you about $833.33 for your bond because $50 per year on that amount is 6%, just like the other bonds available to the investor. The $166.67 difference between the face value and the market value is the discount.

Conversely if the rate being paid on similar bonds is 4% then your $1,000 face value bond would be worth about $1,250 because $50 per year is 4% of that amount. The $250 is called a premium (opposite of discount).

Note that my discount calculations are not accurate because in addition to the promise to receive $40 or $50 or $60 per year in interest the investor is also buying the promise to receive $1,000 (the face value) when the bond matures. So the discount and premium are not quite as extreme as in my example. Also as the maturity date approaches the impact of interest rate changes lessens because there is not as much time over which to earn interest so the effect of the change in interest rate is less.

So don't use my example to price a specific bond (it's more complicated than that) but only to understand the principle of discounts and premiums on bonds.

To fully understand how bonds are priced you need to understand how the present value of a stream of future earnings is calculated, specifically how the discount rate applied can change the result. the principle applies not only to pricing bonds but to pricig any type of investment. What something is worth today depends on how much money it generates over time, including when it is disposed of, and what the probability of actually receiving that money is.

I hope that helps.

Answer 2

it is all about 'yield' it fairly is the go back of a bond relative to its fee. start up with a 5% bond at par (one hundred). The yield is 5% If the bond fee doubles to 2 hundred the yield halves to 2.5% to appreciate this each and every £one hundred nominal will pay £5. If the £one hundred nominal prices £2 hundred you nonetheless obtain £5 £5/£2 hundred *one hundred=2.5% Now seem at yields first. enable's say ordinary charges of pastime are 10%. might want to you pay £one hundred to purely get 5%? of route no longer. with the intention to get 10% from the 5% bond the fee might want to favor to be halved, or £50. it fairly is £2 hundred nominal (fee £one hundred) at 5%=£10 Then £10/£one hundred fee =10% keep in mind the bond pastime cost, or coupon, is fixed so the purely aspect which could replace is the bond fee (and subsequently the yield).

Answer 3

Because principle * rate = fixed interest income; therefore if rate increases principle must decrease to give same amount of fixed interest income.