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03/08/2016 04:25:19 PM

Market Interest Rates and Bond Prices

Once a bond is issued the issuing corporation must pay to the bondholders the bond's stated interest for the life of the bond. While the bond's stated interest rate will not change, the market interest rate will be constantly changing due to global events, perceptions about inflation, and many other factors which occur both inside and outside of the corporation.

The following terms are often used to mean market interest rate:

  • effective interest rate
  • yield to maturity
  • discount rate
  • desired rate

When Market Interest Rates Increase

Market interest rates are likely to increase when bond investors believe that inflation will occur. As a result, bond investors will demand to earn higher interest rates. The investors fear that when their bond investment matures, they will be repaid with dollars of significantly less purchasing power.

Let's examine the effects of higher market interest rates on an existing bond by first assuming that a corporation issued a 9% $100,000 bond when the market interest rate was also 9%. Since the bond's stated interest rate of 9% was the same as the market interest rate of 9%, the bond should have sold for $100,000.

Next, let's assume that after the bond had been sold to investors, the market interest rate increased to 10%. The issuing corporation is required to pay only $4,500 of interest every six months as promised in its bond agreement ($100,000 x 9% x 6/12) and the bondholder is required to accept $4,500 every six months. However, the market will demand that new bonds of $100,000 pay $5,000 every six months (market interest rate of 10% x $100,000 x 6/12 of a year). The existing bond's semiannual interest of $4,500 is $500 less than the interest required from a new bond. Obviously the existing bond paying 9% interest in a market that requires 10% will see its value decline.

Here's a Tip

An existing bond's market value will decreasewhen the market interest rates increase.The reason is that an existing bond's fixed interest payments are smaller than the interest payments now demanded by the market.

When Market Interest Rates Decrease

Market interest rates are likely to decrease when there is a slowdown in economic activity. In other words, the loss of purchasing power due to inflation is reduced and therefore the risk of owning a bond is reduced.

Let's examine the effect of a decrease in the market interest rates. First, let's assume that a corporation issued a 9% $100,000 bond when the market interest rate was also 9% and therefore the bond sold for its face value of $100,000.

Next, let's assume that after the bond had been sold to investors, the market interest rate decreased to 8%. The corporation must continue to pay $4,500 of interest every six months as promised in its bond agreement ($100,000 x 9% x 6/12) and the bondholder will receive $4,500 every six months. Since the market is now demanding only $4,000 every six months (market interest rate of 8% x $100,000 x 6/12 of a year) and the existing bond is paying $4,500, the existing bond will become more valuable. In other words, the additional $500 every six months for the life of the 9% bond will mean the bond will have a market value that is greater than $100,000.

Here's a Tip

An existing bond's market value will increase when the market interest rates decrease. An existing bond becomes more valuable because its fixed interest payments are larger than the interest payments currently demanded by the market.

Relationship Between Market Interest Rates and a Bond's Market Value

As we had seen, the market value of an existing bond will move in the opposite direction of the change in market interest rates.

  • When market interest rates increase, the market value of an existing bond decreases.
  • When market interest rates decrease, the market value of an existing bond increases.
  • The relationship between market interest rates and the market value of a bond is referred to as an inverse relationship. Perhaps you have heard or read financial news that stated "Bond prices and bond yields move in opposite directions" or "Bond prices rallied, lowering their yield..." or "The rise in interest rates caused the price of bonds to fall."

If you were the treasurer of a large corporation and could predict interest rates, you would...

  • Issue bonds prior to market interest rates increasing in order to lock-in smaller interest payments.

If you were an investor and could predict interest rates, you would...

  • Purchase bonds prior to market interest rates dropping. You would do this in order to receive the relatively high current interest amounts for the life of the bonds. (However, be aware that bonds are often callable by the issuer.)
  • Sell bonds that you own before market interest rates rise. You would do this because you don't want to be locked-in to your bond's current interest amounts when higher rates and amounts will be available soon