Inverse Relation Between Interest Rates and Bond Prices (2024)

Bonds have an inverse relationship to interest rates. When the cost of borrowing money rises (when interest rates rise), bond prices usually fall, and vice-versa.

At first glance, the negative correlation between interest rates and bond prices seems somewhat illogical; however, upon closer examination, it actually begins to make good sense.

Key Takeaways

  • Most bonds pay a fixed interest rate that becomes more attractive if interest rates fall, driving up demand and the price of the bond.
  • Conversely, if interest rates rise, investors will no longer prefer the lower fixed interest rate paid by a bond, resulting in a decline in its price.
  • Zero-coupon bonds provide a clear example of how this mechanism works in practice.

Bond Prices vs. Yield

Bond investors, like all investors, typically try to get the best return possible. To achieve this goal, they generally 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; however, zero-coupon bonds alsolock in the bond’s yield, which may be 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 at the present time is 5.26%: (1,000 -950) ÷ 950 x 100 = 5.26. In other words, for an individual to pay $950 for this bond, they must be happy with receiving a 5.26% return.

This satisfaction, of course, depends on what else is happening in the bond market. If current interest rates were to rise, where newly issued bonds were offering a yield of 10%, then the zero-coupon bond yielding 5.26% would be much less attractive. Who wants a 5.26% yield when they can get 10%?

To attract demand, the price of the pre-existing zero-coupon bond would have to decrease enough to match the same 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).

Now that there is an understanding of how a bond's price moves in relation to interestrate changes, it's easy to see why a bond's price would increase if prevailing interest rates were to drop. 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 the bond's yield matched the prevailing 3% rate. In this instance, the price of the bond would increase to approximately $970.87.

Given this price increase, you can see why bondholders, the investors selling their bonds, benefit from a decrease in prevailing interest rates. Theseexamplesalso showhow abond's coupon rate and, consequently, its market price are directly affected by national interest rates. To have a shot at attracting investors, newly issued bonds tend to have 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 any 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 debt securities increases the closer they get to expiring.

Zero-coupon bonds have unique tax implications, too, that investors should understand before investing in them. Even though no periodic interest payment is made on a zero-coupon bond, the annual accumulated return is considered to be income, which is taxed as interest.

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

In other words, taxes must be paid on these bonds annually, even though the investor does not receive any money until the bond maturity date. This may be burdensome for some investors; however, there are some ways to limit these tax consequences.

Bond Prices and the Fed

When people refer to "the national interest rate" or "the Fed," they'remost often referringto thefederal funds rateset by theFederal Open Market Committee (FOMC).This is the rate of interest charged on the interbank transfer of funds held by the Federal Reserve (Fed) and is widely used as abenchmarkfor interest rates on all kinds of investments anddebt securities.

Fed policy initiatives have a huge effect on the price and the yield 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 increases. The opposite happens when interest rates go down: existing fixed-rate bond prices go up and new fixed-rate bond yields decline.

The sensitivity of a bond's price to changes in interest rates is known as its duration.

What Is the Relationship Between Bond Prices and Interest Rates?

The relationship between bond prices and interest rates is an inverse one. When interest rates go up, bond prices go down. When interest rates go down, bond prices go up.

Is It Better to Buy Bonds When Interest Rates Are High or Low?

In general, it is better to buy bonds when interest rates are high if your objective is to maximize returns. When interest rates are high, the yield on a bond is higher, so your investment return will be higher compared to when rates are low.

Do Bonds Go Down When Stocks Go Up?

Typically, when stocks go up, bond prices drop. When stocks go up, it draws investors towards investment in stocks as opposed to bonds. As the demand for bonds decreases, so do their prices, in order to make them more attractive to investors.

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 when new bonds are issued with the higher paying rate (better yield for the investor), it makes existing bonds with the lower rate less attractive. To make these lower-rate bonds more attractive, the price is reduced to entice investors to purchase them.

Correction—August 6, 2023: The correlation between the direction of the federal funds rate and the price and yield of bonds has been corrected to clarify that only new fixed-rate bond yields move, with existing yields holding steady.

Inverse Relation Between Interest Rates and Bond Prices (2024)

FAQs

Inverse Relation Between Interest Rates and Bond Prices? ›

Most bonds and interest rates have an inverse relationship. When rates go up, bond prices typically go down, and when interest rates decline, bond prices typically rise.

Is there an inverse relationship between bond prices and interest rates? ›

Bonds have an inverse relationship to interest rates. When the cost of borrowing money rises (when interest rates rise), bond prices usually fall, and vice-versa.

What is the relationship between interest rates and bond prices? ›

Bond prices have an inverse relationship with interest rates. This means that when interest rates go up, bond prices go down and when interest rates go down, bond prices go up.

Is there an inverse relationship between bond prices and interest rates quizlet? ›

Bond prices and yield vary inversely! Because the cr or IR on the bond is fixed at the time of issue. So, the only way to make the bond yield match the market rate of interest if it rises, is to reduce the bond's price because the interest is fixed for the life of the bond.

Why is there an inverse relationship between investment and interest rate? ›

There is a inverse relation between the rate of interest and investment. If the rate of interest is high then people will take less loan from the bank and they will have less money to invest in whereas if rate of interest is low then people will take more loan from the bank to invest in the business.

Should I buy bonds when interest rates are high? ›

Should I only buy bonds when interest rates are high? There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels.

Should you sell bonds when interest rates rise? ›

Unless you are set on holding your bonds until maturity despite the upcoming availability of more lucrative options, a looming interest rate hike should be a clear sell signal.

Should you buy bonds in a recession? ›

In a recession, investors often turn to bonds, particularly government bonds, as safer investments. The shift from stocks to bonds can increase bond prices, reduce portfolio volatility, and provide a predictable income. However, drawbacks include lower yield potential, default risks, and interest rate risks.

What does an inverted yield curve represent? ›

What is an inverted yield curve? An inverted yield curve means the interest rate on long-term bonds is lower than the interest rate on short-term bonds. This is often seen as a bad sign for the economy.

What influences bond prices? ›

The price of a bond is determined by discounting the expected cash flows to the present using a discount rate. The three primary influences on bond pricing on the open market are supply and demand, term to maturity, and credit quality.

What is the relationship between bond price and interest rate quizlet? ›

What is the relationship between interest rates and bond prices? It is a negative relationship, as bond prices go up, interest rates go down. Bond prices are more sensitive to decrease in interest rates than increases in interest rates.

What is the relationship between the market interest rate and the bond price quizlet? ›

What is the relationship between market interest rates and market bond prices? Market interest rates and bond prices have an inverse relationship; when one goes up, the other goes down.

Does the statement bond prices vary inversely with changes in the market rate of interest? ›

The statement "Bond prices vary inversely with changes in the market rate of interest" means that if the market rate of interest increases, the contractual interest rate will decrease. market rate of interest decreases, then bond prices will go up.

Is there an inverse relationship between the real investment and the real interest rate? ›

Simply put, if the real interest rate increases, firms will demand less investment. Conversely, if the real interest rate decreases, firms will demand more investment, other things being equal.

Which of the following is inversely related to the interest rate? ›

Bond prices and interest rates are inversely related – as interest rates rise, the prices of bonds tend to fall, and vice versa.

Do stocks and bonds have an inverse relationship Why or why not? ›

Historically, when stock prices rise and more people are buying to capitalize on that growth, bond prices typically fall on lower demand. Conversely, when stock prices fall, investors want to turn to traditionally lower-risk, lower-return investments such as bonds, and their demand and price tend to increase.

What drives the price of a bond? ›

The three primary influences on bond pricing on the open market are supply and demand, term to maturity, and credit quality. Bonds that are priced lower have higher yields. A call feature can have an impact on bond prices.

What's an inverse relationship in science? ›

An inverse relationship is one in which the value of one parameter tends to decrease as the value of the other parameter in the relationship increases. It is often described as a negative relationship.

What does Macaulay duration tell us? ›

Macaulay duration is the weighted average of the time to receive the cash flows from a bond. It is measured in units of years. Macaulay duration tells the weighted average time that a bond needs to be held so that the total present value of the cash flows received is equal to the current market price paid for the bond.

Is now a good time to buy bonds? ›

Short-term bond yields are high currently, but with the Federal Reserve poised to cut interest rates investors may want to consider longer-term bonds or bond funds. High-quality bond investments remain attractive.

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