why do prices of bonds decrease when interest rates go up?

Answer 1

In its simpliest form, the price of a bond is determined by the following formula:


Bond Price=Interest Payment/ Market rate of interest.

So if a bond pays $100 interest per year and the market rate is 10%, the bond is worth $1000 ($100/.1)

If the market rate of interest is 9%, the bond is worth $1111 ($100/.09). And if the market rate of interest is 11%, the bond is worth $909 ($100/.11).

Answer 2

Suppose I have $1,000 (the size of the common corporate bond) and go to the bank. They are paying someplace around 3-4 percent. Then I look at the bonds and the ones I am interested in are paying, say 5 percent. If the banks start paying 4-5 percent, then more money might be going to banks instead of bonds--unless the yield for the bonds keeps the same yield. Now if the bond pays the same amount regardless of the price, what has to happen to the price to get the relative rate (the yield) to be a point higher? The price of the bond has to go down. (it works the other way too). Do the math and see for yourself.

(Bonds also fall if the business' prospects and business condition falls, but that is related to risk, the reason why bonds often pay more than money in the bank)

Answer 3

There are two reasons why this happens. A bond's rate of return is set and flexible at the same time. Suppose a company issues a $10,000 bond which yeild 3 percent a year bond and the bond matures in five years. Should banks raise interest rates to seven percent, people dump their bonds on the open market and place the money in the bank. But ultimately in the end both will give the same rate of return. Why is this?

Bonds are different from banks because you get the face value of the bond when the bond matures. So if you have a $10,000 bond that matures on February 28, you get $10,000.

So if banks raise rates to 7 percent, people can sell their bond on the open market and put the money in the bank. HOWEVER, even though it is a $10,000 bond, it may sell for only $8,500 in the marketplace.

So if banks have 10 percent interest rates, instead of putting your money in the bank you may decide to buy a bond that has a face value $10,000 upon maturity. If the bond matures in three years you may be able to buy the bond for $7000 even though it's face value is $10,000 (again you do not get the $10,000 until the day the bond matures).

Your TOTAL rate of return is 3 percent every year, plus a $3,000 capital gain when the bond matures three years and the company pays you $10,000

So in the end bond prices drop when interest rates rise. But because bonds give a capital gain when the bond matures usually interest rates and the rate of return of every bond in the market end up being virtually the same.

In real life the bonds usually pay out a bit more than the bank because bonds are considered more risky than banks. If interest rates rise again, the price you paid for your bond will drop for less than what you paid for it. Regardless, people who buy bonds with varying maturity dates end up getting a bit more than if they put the money in the bank because of the capital gain factor.

Furthermore people can afford to buy a good mixture of bonds because bonds' margin rates are only 10 percent whereas the margin rate for stocks is 50 percent. If interest rates go against the bond investor, because of the lower margin requirement, the investor can buy more bonds that will more than offset his losses should interest rates unexpectedly rise.

Answer 4

Your question is best answered by a simple example: Suppose you own a bond that pays 5%. Now assume that there is an identical bond being issued (same maturity, same risk) but the only difference is that this bond pays 10%. Which bond are you willing to pay a higher price for? the 10% bond, of course. So your 5% bond will have to decrease in value to compensate for its lower yield relative to the higher yielding bond. Hopefully this answers your question without a lot of finance mumbo jumbo.

Answer 5

Current bond price is based on the future cash flow received for the obligation discounted at the current rate. If the interest rate goes up then the discounted value of future cash flow will fall. That is why bond prices decreases when interest rate goes up.

Answer 6

Suppose you have $1000 invested in bonds with 10% coupon rate means you will get $100 annually as interest payment or coupon payment. Suppose if the interest ratemoves up to 11% then to maintain the $100 interest payment your $1000 will have to go down to $909.1 meaning the price of your bond in the market has gone down. 11% of 909.1 is again $100.

Answer 7

If you have a treasury bond paying 5% interest, and tomorrow the Feds start selling bonds paying 6% interest, the only way you can sell your bond is by discounting the price.

Answer 8

Because as interest rates rise, new bonds issued in the market reflect those higher interest rates and are thus more attractive than older, lower interest rate bonds. The inverse is also true. As interest rates fall, older bonds that had higher yields are more attractive, and thus their price goes up.

This also means that longer term bonds are more sensitive and more inversely related to changing interest prices than short-term bonds.

Answer 9

Wow! economics class finally coming in handy! who would have thouht! When interest rates increase people spend less and save more. The bond rates go up so that people will still be able to buy them while saving.

Answer 10

making it simple, who would buy an old bond for 1k at 4% when they can buy a new one at 7%? so the price of the old one comes down, it just isnt worth as much