Inverse Relation Between Interest Rates and Bond Prices

Bonds have an inverse relationship to interest rates. When interest rates rise, bond prices usually fall, and vice-versa.

To those unfamiliar with bond trading, the negative correlation between interest rates and bond prices may be counterintuitive. But it makes sense when you consider that a change in interest rates, up or down, makes bonds that were previously issued more or less lucrative to investors in comparison with new bonds issued after the change in interest rates.

Bond Prices vs. Yield

Bond investors, like all investors, try to get the best return possible. To achieve this goal, they need to keep tabs on the fluctuating costs of borrowing.

An easy way to grasp why bond prices move in the opposite direction of interest rates is to consider zero-coupon bonds, which don't pay regular interest and instead derive all of their value from the difference between the purchase price and the par value paid at maturity.

Zero-coupon bonds are issued at a discount to par value, with their yields a function of the purchase price, the par value, and the time remaining until maturity. Zero-coupon bonds also lock in the bond’s yield, which is attractive to some investors.

Zero-Coupon Bonds

If a zero-coupon bond is trading at $950 and has a par value of $1,000 (paid at maturity in one year), the bond's rate of return will be 5.26%: (1,000 - 950) ÷ 950 x 100 = 5.26. In other words, an investor can pay $950 for this bond and get the money back plus a 5.26% return a year down the road.

Is that a good deal? It depends on what happens in the bond market during that year. If current interest rates were to rise, newly issued bonds might offer a yield of 10%. The zero-coupon bond yielding 5.26% has become much less attractive in the bond market.

To attract demand in the bond market, the price of the pre-existing zero-coupon bond would have to decrease enough to match the return yielded by prevailing interest rates. In this instance, the bond's price would drop from $950 (which gives a 5.26% yield) to approximately $909.09 (which gives a 10% yield).

That is how a bond's price moves relative to interest rate changes.

When Interest Rates Drop

Of course, interest rates might also drop during the year before that bond matures.

If rates dropped to 3%, the zero-coupon bond, with its yield of 5.26%, would suddenly look very attractive. More people would buy the bond, which would push the price up until its yield matched the prevailing 3% rate. In this instance, the price of the bond would increase from $950 to about $970.87.

Given this price increase, you can see why investors selling their bonds benefit from a decrease in prevailing interest rates. These examples also show how a bond's coupon rate and, consequently, its market price are directly affected by interest rates.

To attract investors, issuers of new bonds tend to offer coupon rates that match or exceed the current national interest rate.

Zero-Coupon Bond Details

Zero-coupon bonds tend to be more volatile as they do not pay periodic interest during the life of the bond. Upon maturity, a zero-coupon bondholder receives the face value of the bond. Thus, the value of these bonds increases the closer they get to expiring.

Zero-coupon bonds also have unique tax implications. Even though no periodic interest payment is made on a zero-coupon bond, the annual accumulated return is considered to be income and is taxed as interest income.

The bond is assumed to gain value as it approaches maturity, but this gain in value is not viewed as capital gains, which would be taxed at the capital gains rate, but rather as income.

That means taxes must be paid on these bonds annually, even though the investor does not receive any money until the bond maturity date.

Bond Prices and the Fed

When people refer to "the national interest rate" or "the Fed rate," they're usually referring to the federal funds rate set by the Federal Open Market Committee (FOMC). This is the rate of interest charged for the interbank transfer of money held by the Federal Reserve and it is used as a benchmark for interest rates on all kinds of investments and debt securities.

Fed policy initiatives have a huge effect on the prices and the yields of bonds. When the Fed increases the federal funds rate, the price of existing fixed-rate bonds decreases and the yields on new fixed-rate bonds increase.

The opposite happens when interest rates go down: existing fixed-rate bond prices go up and new fixed-rate bond yields decline.

The Bottom Line

Interest rates and bond prices have an inverse relationship. When interest rates go up, the prices of bonds go down, and when interest rates go down, the prices of bonds go up.

This happens because new bonds are issued with a higher yield, making existing bonds that were issued with a lower rate less attractive. The prices on these lower-rate bonds must be reduced to make them attractive to buyers.