Bonds and Interest rates 101 by Jim Schultz

25 Sep

What is a bond?
A bond is a term used to describe a type of debt. A company might sell bonds to raise money from investors at a certain interest rate (the bond’s coupon rate) over a period of time (until the bond’s maturity).

To make bonds easier to understand, we can think of them like borrowing money from a bank or a credit card. If a bank loans us $10,000 at a 5% interest rate, they have in essence bought a bond from us. To get money from the bank now, we agree to pay them back the initial loan amount plus interest over a set period of time. Similarly, companies selling bonds get money from bond investors now and pay it back plus the coupon rate over the bond’s maturity.

Bond Prices and Interest Rate Changes
One of the interesting things about bonds is what happens to their price when interest rates change. When interest rates go up or down, bonds in the market get comparatively more or less desirable, which affects their price.

When interest rates go up, bonds with lower rates become less attractive decreasing their price.
When interest rates go down, bonds with higher rates become more attractive increasing their price.
What would happen to the price of the $10,000 loan with 5% interest, if the market rate for similar loans went up to 6%?

If a bank can originate new loans at a higher interest rate, the price of the lower rate loan will go down. All else being equal, getting paid 6% on a $10,000 loan is preferable to getting paid 5%. Banks will prefer to make new loans at the higher 6% rate, which will lead to a decrease in the 5% loan’s price.

What if interest rates instead go down?

If interest rates go down to 4%, the price of the higher rate loan will go up. Getting paid 5% is better than getting paid 4% (all else being equal). The 5% loan will become more valuable because it has a higher yield than the bank’s alternatives. Banks will pay more for the 5% loan because it offers a better return, which will increase the loan’s price.

Bond Prices and Yield
As the price of a bond or loan changes, the effective yield it pays out will also change.

For example, a loan that costs $10,000 that pays $500 in interest gives a 5% yield ($500/$10,000). If interest rates increase and the price of the loan goes down, the loan’s yield will increase. If the price of the loan goes down to $8,000, the $500 in interest will now give the loan a 6.25% yield ($500/$8,000). The prices of existing bonds change to make their yield equal to the current yield of bonds with similar risk and maturity.

Investors trade bond products to maximize returns for similar risks. As interest rates change, bond prices and yields will adjust to reflect the current market rates.

When interest rates go up, bond prices go down and their yields go up.
When interest rates go down, bond prices go up and their yields go down.

Bonds Recap
Bonds prices have an inverse relationship to interest rates.
Bond prices have an inverse relationship to yields.

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