Why do bond yields rise when market rate interest goes up, also what does this have to do with the coupon?

Question

I'm so confused how bonds work. Also what do you anticipate will happen to bond prices and yields to both treasury and corporate bonds.

Answer 1

Interest rates go up ---> Bond prices fall
Interest rates go down ---> Bond prices rise

As long as the bond's issuer remains stable, the bond gives the investor a guarantee that the issuer will make the interest (or coupon) payments at certain intervals and will then pay back the original sum of money lent (the principal) at a specified date (the maturity date). It is because of this that most investors assume high-quality bonds have no risk.

The problem occurs if you wish to sell your bond before it matures, on the secondary market. If interest rates have risen since you bought your bond, newly issued bonds will be sold with higher coupon payments than what your bond pays. As a result, no other investor will buy your bond at the par price. They can, instead, purchase a newly issued bond at par price, but one that pays higher interest. So, in order to make your bond competitive, you would have to sell it at a discount. The discount necessary would be the price at which your old bond yields the same interest to the new investor as the newly issued bonds would. Remember that bonds are only issued and redeemed at par. What happens in between is based on free market forces.

Here’s an example. Let's say that you bought a 10-year Treasury bond on the day of its issue, at $1000 par. It was issued with a 5% coupon rate, meaning that it pays $50 per year in interest. A year later, you decide to sell. So you decide to sell your bond on the secondary market to get your money back. But the Fed has raised interest rates. Now, 10-year Treasury bonds are being issued with a 7% coupon rate. These new bonds are sold at $1000 par and pay $70 per year in interest. You cannot simply sell your bond at its par price of $1000 because no rational person would buy it from you at that price. They would buy the new bonds instead. In order to sell your bond, you would have to lower its price to around $714. Your bond still pays $50 per year in interest, as is stipulated in the bond's contract. But now, the new owner buys it for $714 and receives $50 per year in interest, which calculates to a 7% interest rate (50 divided by 714 = 0.07), the same as newly-issued Treasuries.

The actual coupon payment has not changed. Rather, the ratio of that coupon payment to the price has changed. In a secondary market where people can choose to sell their bonds before maturity, prices of outstanding bonds will fluctuate based on prevailing interest rates. This is because current interest rates influence newly-issued bond coupon rates, which compete with outstanding bonds. The outstanding bonds still pay the same coupons and are redeemed at the same par amount on the maturity date, but their selling prices will fluctuate while outstanding.

As things look now, the Fed is not going to be lowering interest rates any time soon. If anything, investors are worried about the Fed raising interest rates some more. So, the best way to get face value for your specific bond is to hold it until it's maturity date.

Of course, if you are referring to a savings bond, then none of the above applies, because you cannot sell savings bonds on the secondary market.
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Answer 2

You have to talk about two different situtations.
1. The issuance of new bonds.
2. The price of bonds already on the market.

1. For the most part interest rates move and lock step fashion with a rate based on risk, low to high, US Treasury bonds, municiple bonds, mortgage bonds, corp bonds, high yield corp bonds, etc.
2. The price of an existing bond moves inversely with interest rates. The coupon rate will never change as it based off par, usually $1000, ie 8% pays $80 per year. The effictive rate will change based on the price paid.

Answer 3

If the market interest rate rises, the bond price falls; your fixed coupon rate bond is not as attractive as it previously was. Now that the price has fallen, the fixed return on the bond when divided into that lower price, which is the bond yield, rises.

If you are doing bond calculations, calculate the theoretical price and yield of a bond at two market interest rates to see this.

Answer 4

Thanks to SWH for copying and pasting my words in a previous answer that I made a week or so ago. He basically copied a few paragraphs from Chapter 11 of my book. ( I recognize my own writing.) However, I suppose that imitation is the most sincere form of flattery. So, thank you SWH. I know that you aspire to be just like me ... and perhaps someday you will. I'm pulling for you, buddy.

Here's my original response: http://answers.yahoo.com/question/index;_ylt=AgImOUQQu9CirqDG9CcVxRzty6IX?qid=20070701160434AAqa3Vi&show=7#profile-info-GXffVZMFaa

Download my free book at http://www.invest-for-retirement.com and go straight to chapters 10, 11, and 12. They will explain bonds in an easy-to-understand format. Chapter 11 explains why bond prices go up and down in relation to changes in interest rates.

Interest rates go up, which causes outstanding bonds to fall in price. Since the coupon payment of a bond is fixed, per the bond's contract, and now the selling price of the bond is lower, its "current yield" rises. See, there are three different types of yields: the coupon yield, the current yield, and the yield to maturity.

Answer 5

If interest rates go up, your $1000 bond will decrease in value. Since the coupon if fixed for the life of the bond and can't go up, the only way the effective interest can go up is for the bond price to decline.

$1000 bond paying $60 per year (6.00%)
$990 bond paying $60 per year (6.06%)

The amount that the bond price declines is related to the number of years to maturity. This is because at maturity, the full face value of the bond will be returned.

$990 bond paying $1000 in 5 years (a capital gain of $10) over 5 years (about 0.20% annualized return).

$990 bond paying $1000 in 30 years (a capital gain of $10) over 30 years (about 0.0335% annualized return).

Longer maturity bonds will decline more than shorter maturity bonds when interest rates go up.

Answer 6

They will continue to go up and down just as they have for the past 75 years. The trick is to buy them at the right time.

Answer 7

It takes six seconds for the Yahoo Answers question to load for me to be able to click on the [add your answer] button. thus, is my laptop slow?