You may not know it, but bond prices and interest rates have an inverse relationship, which means they move opposite of each other. When interest rates rise, bond prices fall. And when interest rates fall, bond prices rise. There’s a reason for this relationship.
Bonds can be purchased in primary and secondary markets. In the primary market, bonds are purchased directly from the bond issuer, which may be a government agency or a company. In the secondary market, bonds are purchased from an investor who currently holds the bond.
To understand how bond prices and interest rates have an inverse relationship, you have to understand how bonds work. When you purchase a bond, you’re loaning money to an entity for a certain period of time. The same way you pay interest when you take out a loan, the bond issuer pays you interest in the form of coupon payments for a certain period of time. This continues until the bond matures and you get back the full value of the loan. The coupon payment is made semi-annually based on the interest rate.
For example, if you have a $1,000 bond with a 4% interest rate, you’ll get $40 annual coupon payments, or $20 twice a year.
A few years from now – or maybe even a few months from now – the interest rate on newly issued bonds probably won’t be the same as the rate on the bond you’re holding. If you want to sell your bond in the secondary market, you might be able to sell it for a higher or lower price depending on how current interest rates compare to the rate on the bond you’re holding.
Let’s say interest rates have increased from 4% to 6% and you want to sell your bond to another investor. While you may have paid $1,000, no other investor would pay that amount considering they could pay less for a bond in the primary market that pays a higher interest. Since coupon payments will remain at $40 per year no matter what, you’d have to lower your selling price to $666.67 so the new buyer would still get a 6% interest rate. This is how bond prices fall as interest rates increase.
What if, on the other hand, interest rates drop from 4% to 2% and you decide you want to sell your bond? You may already see how the bond you’re holding is more valuable than bonds being issued on the primary market. Remember, that the coupon payment has to remain the same, so to match the interest rate to the bond price, you’d have to sell the bond for a $2,000 handsome profit.
The value of a bond is based on the amount of income it produces relative to the bond price. If you have a bond with a $500 coupon payment and similar bonds are currently paying only $100, your bond is more valuable. You can demand a higher price. On the other hand, your bond with its $500 coupon payment is less valuable than bonds currently paying $750. You’d have to sell you bond at a discount.
Since you know that bonds and interest rates change, you should use that in your decision to buy a short- or long-term note. If you buy a long-term bond with a low interest rate, you’ll be stuck with that low rate perhaps until maturity because other investors will have little incentive to buy it. Likewise, if you buy a short-term bond at a high interest rate, you might not be able to get the same interest rate after your bond matures. So, in general, you want to buy short-term bonds when rates are low and long-term bonds when rates are high. Regardless of how interest rates rise and fall, you’ll always get the face value of your bond when you redeem it at maturity.