What is the relationship between interest rate and bond prices?

We’ll start with a few facts about investing, and the relationship between interest rates and bond prices:

– Rising share prices and property values make for happy investors.

– An increase in interest rates results in higher term deposit rates and again, investors are pleased.

– An increase in bond yields however, does not always please investors. In fact, if often leaves them confused and uncertain about the impact on their bond investments.

Read on to learn more about the relationship between interest rates and bond prices.

The relationship between bond price and yield

There are two key components to be aware of when you buy a bond – its price and its yield.

When you buy a bond, you are effectively making a loan to that corporation. In return for borrowing your money, the bond is repaid in a specified time period. And, for the duration of the loan, you are rewarded with regular coupon (or interest) payments. A bond’s yield is the total value of these payments over the lifetime of the bond, incorporating the $100 face value received at maturity. It is the total return the investor can expect to receive, subject to no default.

The coupon payment amounts are set at the time the bond is issued, according to prevailing interest rates. The yield is generally higher than the cash rate, to make the bond a more attractive investment than a term deposit¹.

If you buy a bond when it is issued and hold it through to maturity, the investment will not be affected by changes to interest rates. As illustrated in figure one, coupon payments remain the same for the duration of the investment, and at maturity, the face value is repaid.

Key point #1 – a bond bought at issue and held to maturity is not affected by changes to interest rates

Figure one: A bond bought at issue and held to maturity

Bond prices and interest rates

Key point #2 – a bond’s price moves in the opposite direction of its yield

A buy and hold strategy is straightforward. However, if you wish to buy (or sell) a bond on the secondary market (i.e. after it has been issued), the relationship between the bond’s price and its yield becomes important.

This relationship is sometimes depicted as a see-saw – as one rises, the other falls. As illustrated in figure two, the two factors have an inverse relationship; in other words, a bond’s price moves in the opposite direction of its yield.

Figure two: the effect of interest rates on bond yields and bond prices

Why bond prices and yield are inversely related

The price of a bond reflects the value of the income it provides via regular coupon or interest payments.

The relationship between interest rates and bond prices:

• If interest rates rise, term deposits and newly issued bonds will pay investors higher rates than existing bonds. Therefore, the price of older bonds will generally fall to compensate and sell at a discount. This is currently that case for many of the XTBs available on exchange.
• If interest rates fall, the value of investments related to interest rates fall. But bonds that have already been issued will continue to pay the same coupon amount as they did previously – a rate which was based on a higher interest rate at the time they were issued. These older bonds then become a more attractive proposition and will generally sell at a premium.

Key point #3 – when a bond sells at a discount, its price is lower than its issue price. When it sells at a premium, its price is higher than its issue price.

How the bond price and yield relationship affects XTBs

As well as an original face value and coupon rate, each XTB has a current price, a current yield determined by its coupon rate and price, and a yield to maturity.

We provide a table of available XTBs, which is updated daily using the previous market close data. This interactive table provides details of the available XTBs, and includes fixed and floating rate bonds across a range of sectors.

Figure three: Key measures of a corporate bond

Source: QANTAS XTB – YTMQF4 28 OCT 2022

Figure three details the data you should review when considering an investment in a Qantas QF4 XTB. This example shows an XTB where interest rates have increased (the current yield is higher than the coupon rate). Therefore, this XTB’s current price is lower than its face value:

• The coupon rate of 2.95% would be paid to those investors who bought at issue (at $100) and held to maturity
• An investor who bought at issue and sold this XTB today would lose from the price depreciation
• An investor buying the XTB today would pay a lower price than its face value
• An investor buying the XTB today, would benefit from price appreciation as the bond price is pulled to the $100 face value at maturity.

View the range of available XTBs

Key point #4 – the Yield to Maturity is the ‘total return’ you should receive if you buy the bond today and hold it to maturity

If you are considering XTBs for your portfolio, use the tools available to help you determine the most appropriate investment(s), given your income needs and likely investment time frame.

¹Term Deposits may enjoy the benefit of protection under the Financial Claims Scheme.

This article was first published in August 2017, updated in February 2021 and October 2022

Disclaimer

The information in this article is general in nature. It should not be the sole source of information. It does not take into account the investment objectives or circumstances of any particular investor. You should read the PDS that relates to that Class of XTB prior to making an investment decision and consider, with or without advice from a professional adviser, whether an investment is appropriate to your circumstances. Australian Corporate Bond Company Limited is the Securities Manager of XTBs and will earn fees in connection with an investment in XTBs.

Bonds are a debt-based investment where an individual loans money to a government or corporation. They do so on the condition that the borrower will pay the money back when the bond reaches its date of maturity (expiry), plus any coupon payments that are due.

A bond’s coupon is the periodic return that an investor will receive for loaning the value of the bond to the borrower (a government or corporation). For example, a bond with a £1000 value and a 5% interest rate will have cash flows (coupons) of £50 a year until it reaches it maturity. If the bond’s maturity was ten years, then the trader would receive £500 in total from the coupon payments, as well as their initial £1000 investment back once the bond reaches its maturity.

Because a bond’s coupon is fixed, demand for the bond – and its price – will shift as the interest rates available elsewhere increase or decrease.

All else being equal, if new bonds are issued with a higher interest rate than those currently on the market, the price of existing bonds will decline as demand for those bond falls. Equally, if new bonds are issued with a lower interest rate than bonds currently on the market, the price of existing bonds will increase in line with demand.

The degree to which a bond’s price will change given any shift in interest rates is calculated by assessing the present value of the bond’s future cash flows. This is because traders use a method known as discounted cash flow to value a bond according to the future returns that they could expect.

Under the discounted cash flow (DCF) method, the theory goes that an investor with an expectation of a 5% annual return would be indifferent in receiving £47.62 today or £50 a year from now. As illustrated in the table below, a bond’s price is based on the sum of all of its discounted cashflows – each future payment the investor expects to receive.

Find out more about government bonds

In this case, the 5% bond would be discounted by the market to the point where its present value, based on its future cash flows, is proportionate to the cash flows of the newer bond. The table above shows that a bond with a 5% interest rate would be adjusted to a market value of £693 because investors discount its cashflows by 10% – the interest rate on the newer bond. This is the maximum that investors would be willing to pay for the bond based on its projected future earnings according to the discounted cash flow.

This new value is calculated by adding up all of the discounted cash flows of the current bond using a 10% yield rate. For the purpose of this example, we would divide the £50 coupon by an annual return of 10% (1.10) to the power of the number of years they investor would be waiting for the cashflow. For the first year, this would give us £45.50 – which is the adjusted return for the 5% bond now that new bonds with a 10% interest rate have been released onto the market.

To get the second year’s return, we would divide £50 by 1.10 to the power of two; for the third year, we would do the same to the power of three and so on. The final year is £1050 divided by 1.10 to the power of ten, because this is the year in which the trader would receive back their initial investment for the bond, as well as the coupon payment.

In selling their bond at a discount, the trader would be losing money. However, they would be receiving instant capital with which they could take a position on another investment which could yield higher returns than their 5% bond, given the existence of 10% bonds on the market.

If a trader held a bond with a 10% interest rate, but a new bond was issued with an interest rate of 5%, they would be able to sell their bond at a premium on the secondary market if they wanted to dispose of their investment. The table below shows how the bond’s price would adjust as market participants’ expectations for returns shift from 10% to 5%.

The bond would trade at a premium because the market would adjust the price of the 10% bond to a point where its present value, based on its future cash flows, is proportionate to the lower cash flows that investors could expect from the newer bond.

In this example, the table above shows that a bond with a 10% interest rate and an initial value of £1000 would be adjusted to a value of £1386 on the secondary market according to the discounted cash flows of the new 5% bond.

This price will become what investors are willing to pay for the 10% bond on the secondary market. As with the previous example, the figure of £1386 is calculated by adding up the discounted cash flows of the current bond using a 5% interest rate.

For the purposes of this example, we would divide the £100 coupon by an annual return of 5% (1.05) to the power of the number of years the investor would be waiting for the cashflow. This would give us an adjusted return of £95.24 for the first year. To get the second year, we would divide £100 by 1.05 to the power of two; for the third year we would do the same to the power of three and so on. The final year is £1050 divided by 1.05 to the power of ten, because this is the year in which the trader would receive back their initial investment for the bond, as well as the coupon payment.

In selling the bond at a premium, the trader would be gaining more profit than their initial investment would have yielded. As a result, they could reinvest this new capital into other opportunities in an attempt to get higher returns than are currently available on the 5% bonds.

Perhaps the most important thing for a trader to bear in mind when trading bonds is that any changes in interest rate expectations will affect the return on their bonds – whether that change is positive or negative.

Additionally, bonds with a longer maturity will be more affected by any changes in interest rates because of the way that investors discount their cashflows. Bonds with longer maturities tend to offer higher yields to compensate the investor for interest rate risk. In this article, the bonds in both examples had a 10-year maturity for the sake of simplicity.

You can also speculate on the inverse relationship between long-term interest rates and bond prices with IG’s government bond futures markets. Here, you can trade on government bonds with a CFD account, which both enable you to speculate on which way you think bond prices will move.

You would go short if you think that a bond will fall in value or long if you thought that it will rise.