Victor Ovejero

Whenever people talk about bonds, I kind of know what they are talking about, but I always get lost withing the nitty gritty and reasoning behind losing or winning money. This is simply because I forget, I don’t think about the concept of bonds for 2 or 3 months and when I hear about it again, I forgot what I learnt last time.

I am sure that many more feel this way, and so I wanted to make a reasonably clear explication to a basic concept about bonds: The relationship between bond prices and interest rates.

*Keep in mind, this is just to rationalize and understand it, even if the explication is not 100% correct, I believe it still helps people visualize the concept.*

Bonds and Interest Rates – Simple Explanation

Bonds are a way for institutions to borrow money from individual investors, by offering a “juicy” interest rate in return.

Bonds have a par value which will always be fixed as a final payment by the issuer to the owner of the bond. Additionally, bonds have a coupon, which is a fixed interest rate that will be paid out periodically to the holder of the bond.

Interest Rates go up?

• If interest rates go up, the economy becomes more risky, meaning the government and banks are only willing to give out money at higher rates (it costs more to borrow).
• Additionally, newly issued bonds will pay a higher rate than the one bought before the interest rates went up, so if you try to sell your bond, the offer will seem less attractive because the coupon seems low to what the coupons of newer bonds are, so the price of the bond will go down naturally.

This is what it means when people say that bond price and interest rates have an inverse relationship! When interest rates go up, older bonds’ attractiveness go down, reflected in their initial value (ALWAYS KEEPING ITS COUPON AND FINAL “PAR” VALUE THE SAME)

To better understand this, we have to imagine the people as the bank of the issuer (of the bond). We are letting the issuer borrow our money for a certain interest rate, if the Central Bank increases the interest rate, investors should expect higher returns for lending money, and thus the issuer increases the attractiveness of their bonds (coupon rates) so investors are still interested in buying them.

💡 No investor will accept a bond with a lower coupon rate than the actual interest rate (unless at discounted price).

This is because, naturally, if the coupon rate is lower than the interest rate, the investor is giving away money cheaper than the banks. He/she could go to any other institution out there and offer to give them money for the actual interest rate, making more money than by buying the aforementioned bond.

This is why bonds need to have a higher coupon rate than the interest rate, because if not it would make the investor lose money, as anybody willing to borrow money will accept the actual interest rate.

Hope this helped you in any way, shape or form! It certainly helped me.

Good luck! 🙂