Why do bond prices fall when interest rates and yields rise? This article explains the basic concepts of bonds and the principles of price fluctuations in an easy-to-understand manner.
Why do bond interest rates and bond prices move in opposite directions?
The relationship between bond interest rates (yields) and bond prices, which move in opposite directions, is one of the most difficult financial concepts to understand. Common sense tells us that when bond rates go up, the interest income earned on bonds goes up. So why do bond prices fall? When yields rise, the prices of other investment products such as stocks, real estate, and cryptocurrencies also rise.
How should we understand the phenomenon that bond yields and bond prices are inversely proportional? In this blog post, I will look at two obstacles that hinder our understanding of bonds. It would be a great help to understand bonds if you knew that the words “interest rate” and “price” used in business news and financial reports to refer to bonds are not the same as the “interest rate” and “face value” written on the bond certificate, and that, unlike other investment products, the amount of profit that can be earned after a certain period of time is predetermined.
Misconceptions and the truth about bonds
Before we explain bonds, let’s first look at the paragraph taken from a newspaper article. How does the article describe the relationship between bond interest rates and bond yields? The article was published in August 2018, when the United States and Turkey were in the midst of a tariff war.
The U.S. dollar continued to strengthen amid growing concerns that Turkey’s currency crisis could spread to other countries, including Europe. As the buying of US Treasury bonds, which are considered safe-haven assets, increased, the interest rate on the bonds fell. The preference for the dollar and US Treasuries continues to grow. (…) Interest rates on US Treasury bonds have been on a downward trend (bond prices are rising). This is due to increased buying of US Treasuries as investors’ fears over the Turkish financial market turmoil have increased. In the New York bond market, the yield on the two-year Treasury note fell 0.053% to 2.6% per annum. The yield on the 10-year Treasury note fell 0.076% to 2.859% per annum. The 30-year Treasury yield fell 0.064% to 3.017%. The price of a Treasury bond moves in the opposite direction of its yield.
If you can easily understand the content of this article, you don’t need to read this blog post. That means you have a clear understanding of the inverse relationship between bond rates and bond prices, and how investors’ outlook on the financial market affects the demand for bond investments. However, if you are not interested in the economy, it is difficult to understand.
It is understandable that the growing concern over the potential spread of the economic crisis in Turkey has led to an increased preference for the US dollar and government bonds, which are considered relatively safe assets. But the problem is bonds. Why have bond yields fallen even though investors have been buying U.S. Treasuries and pushing bond prices up? The article says that “bond prices move in the opposite direction of interest rates,” but it doesn’t explain why. First, we need to understand exactly what a bond is. A bond can be simply described as “an IOU given to someone in exchange for money. Just as a promissory note contains information such as when the money will be repaid, how much interest will be charged, whether the interest will be paid in installments or added to the principal at maturity, and whether it will be compounded or simple, a bond contains the same information. However, the terms used to describe these items are slightly different.
First, the most common type of bond is a “coupon bond,” which pays interest in installments at regular intervals. Coupon bonds have a “face value,” which is the amount to be repaid at maturity, a “maturity date,” which is the date on which the money is paid, and a “coupon rate,” which is the rate of interest paid to the bondholder each year. Interest is paid in installments every three months, six months, or one year, depending on the bond. Like a promissory note, it states how much money is being borrowed, for how long, at what interest rate, and how often interest will be paid. Bonds are similar to IOUs because they are issued by governments, local governments, corporations, and public institutions to borrow large sums of money from an unspecified number of people at once. The difference is that bonds are financial instruments that can be freely bought and sold in the securities market.
So what kind of profit can investors make by investing in bonds? There are two ways that investors who invest in stocks can make a profit. They can either make a profit through capital gains, or they can make additional profits by receiving dividends. Bond investors make profits in similar ways. The way to make capital gains on stock investments is simple. If you buy stocks when they are cheap and sell them when they are expensive, the difference in price is your profit. Bond investors can also make a profit by buying bonds traded in the market when they are cheap and selling them when they are expensive. Because bonds have a maturity date, investors can make a profit by buying them for less than their face value and holding them until maturity. Conversely, if an investor buys a bond for more than its face value and holds it to maturity, incurring a loss, the loss is called a capital loss. In addition to capital gains and interest income, bonds can also generate additional investment income by paying a fixed rate of interest.
Now let’s find out why bond interest rates and bond prices move in opposite directions, and why prices fall when interest rates rise. To properly understand bond interest rates and bond prices, it is necessary to understand exactly what the terms interest rate and price refer to. The interest rate and price of a bond mentioned in an article or report do not refer to the interest rate and face value printed on the paper bond. The word “interest rate” here refers to the rate of return that can be earned by buying the bond and holding it until maturity. The bond price refers to the buying and selling price of the bond in the marketplace.
No matter what unusual things happen in the world, the face value and the nominal interest rate printed on the paper itself will never change. The only things that change according to the market situation are the transaction prices circulating in the market and the expected investment returns when the bonds are purchased. It is important to realize that the interest rates and bond prices quoted by financial institutions and the media are the investment yields and transaction prices in the market. This is the first step in understanding the relationship between bond rates and bond prices. You may be thinking, “Isn’t that obvious?” But more people than you might think confuse the terms “bond yield” and “price” with “face value” and “par value.
So why do bond yields and bond prices move in opposite directions? When the yield goes up, the price of the bond goes up, and when the yield goes down, the price of the bond goes down. This is a natural phenomenon. Why does this not apply to other investment products such as stocks and real estate?
The reason is simple. Unlike other investment products, bonds are products that have a fixed return that can be collected after a certain period of time, i.e. at maturity. Bonds have a fixed amount that the owner can get back at maturity and an interest rate for the interest that can be received at regular intervals. And because it is a product with a predetermined profit that can be earned if held until maturity, the lower the bond is purchased in the market, the higher the investment return, and the higher the bond is purchased, the lower the investment return. If the amount of money that can be earned after a period of time is fixed, it is natural that the lower the bond is purchased, the greater the profit. Therefore, the bond’s trading price and yield move in opposite directions.
For example, let’s say there is a bond with a face value of $100 and a market price of $100. If you buy this bond, you will get back $105 in one year, including $5 in interest. In this case, the annual yield on this bond is 5%. But for some reason, the price of the bond has dropped to $95. If you buy this bond now for $95 and receive $105 a year later, the annual yield will be about 10.52%. Since the amount of money you can receive at maturity is fixed at $105, the lower the price of the bond, the greater the return.
On the other hand, what happens if the price of the bond goes up? Let’s say the price of the $100 bond we mentioned earlier rises by $5 to $105. This is the same amount of money you will receive when you cash it in a year from now. Even if you invest, you will not make a profit. The annual rate of return is 0%, so it is actually a loss when the rate of inflation is taken into account. If the price of the bond rises by $5, the return on the investment, which was 5%, falls to 0%. This is why the bond price and the yield move in opposite directions.
Why does the price of a bond change?
So why do the prices of bonds traded in the market change? Like any other product, the price of a bond is determined by supply and demand. If demand is greater than supply, the price will naturally rise, and if demand is less than supply, the price will fall. The supply of bonds from large issuers such as governments, local governments, financial institutions, public institutions and corporations does not fluctuate much unless there are special circumstances. Therefore, changes in bond prices are often driven by demand, or how many investors are looking for the bond.
There are many conditions that affect bond prices, but the most important of these is the prime rate. The federal funds rate, which is set by the central bank, reflects market participants’ overall predictions of where the country’s economy will go in the future. Investors move based on a careful analysis of whether the federal funds rate will rise or fall and how many times a year the central bank is expected to change the federal funds rate. The federal funds rate is an important measure of the relative returns of all investment products, not just bonds. The market rate, which is set by private financial institutions, also moves in the same direction as the federal funds rate.
Let’s take an example of a bond with a face value and a selling price of $100 and an interest payment of $5 after one year. If the market interest rate set by private financial institutions such as banks is 3%, it is profitable to invest in bonds because the annual investment return on bonds is 2% higher. Investors should be interested in investing in bonds. Suppose the Bank of Korea raises the prime rate for commercial banks to 10%. In this case, you can earn $110 just by saving $100 in a bank for one year. Then, after a year, no one will buy bonds that can only be redeemed for $105. Eventually, the price of those bonds will fall because fewer people want them. To help you understand, I have assumed an extreme situation in which the market interest rate suddenly jumps from 3% to 10%, but of course it is unlikely that interest rates will jump that high.
Eventually, as the federal funds rate rises, the relative investment returns of existing bonds in circulation will fall. Newly issued bonds will offer higher interest rates to reflect the interest rate level, so existing bonds with lower interest rates will become less popular. As demand falls, bond prices will naturally fall.
Finally, to help you understand bonds, we will also look at the types of bonds, which are divided according to the method of interest payment, the issuer of the bond, and the time until maturity and redemption. Bonds are divided into coupon bonds, discount bonds, compound bonds, and perpetual bonds based on the method of interest payment. Discount bonds are bonds sold to investors at a price lower than the face value written on the bond when it is first issued. The face value minus the issue price is considered the actual interest. Compounded bonds are bonds that do not pay interest in the middle, but instead add the interest to the principal and calculate the interest on a compounded basis. Investors receive the principal and the compounded interest at maturity. Finally, perpetual bonds are bonds without a maturity date, meaning that the debt is not due until the maturity date. These are bonds that pay interest regularly for a set period of time. Although they are called perpetual bonds, the contract includes a condition that the issuer can repay the money after a certain period of time, so the principal can be repaid if the condition is met.
The type is also distinguished by where the bond was issued. As the names suggest, government bonds are bonds issued by the government, and municipal bonds are bonds issued by local governments. Similarly, corporate bonds are bonds issued by corporations, and financial bonds are bonds issued by financial institutions such as banks. Bonds can also be divided according to their maturity and repayment period, with bonds with a maturity of one year or less being classified as short-term bonds, those with a maturity of between one and five years as intermediate-term bonds, and those with a maturity of five years or more as long-term bonds.
