Bonds can be a very profitable investment. They can provide you with income and strengthen your portfolio. Understanding the relationship between bond prices and interest rates involves two things. First, a bond’s effective interest rate (called the yield) depends on the bond’s market price. Second, market interest rates are the most important, though not the only, factor affecting bond prices.
Price, Rate, and Yield
Bonds pay a fixed percentage of their face value in interest, called the coupon rate. For example, if a $1,000 face value bond has a coupon rate of 8 percent, the bond pays $80 in interest each year. Now, suppose the bond price falls to $800. You invest less to buy the bond. Your effective interest rate (yield) is the fixed interest divided by the price. Eighty dollars divided by $800 is 10 percent. This works in reverse as well. If the bond price rises above the face value, you invest more. The yield you get goes down.
Investors buy bonds mainly for the income they provide. For this reason, prevailing interest rates are the biggest factor affecting bond prices and in turn, bond yields. Here’s why. Suppose you buy a $1,000 bond that matures (will be paid off) in ten years. The bond pays a 5 percent coupon rate, just about what similar bonds are paying. Three years later, interest rates are up to 8 percent and you decide moving your money to a better-paying bond makes sense. But you have a problem. Other investors aren’t going to pay you $1,000 for your bond because they can invest that money in bonds paying the new market rate of 8 percent. In order to sell your bond, you’ll have to discount (lower) the price. The same principle holds true when interest rates fall. Then, existing bonds are paying more than the market rate. To buy one of these bonds, you’ll have to pay a premium price -- that is, more than the face value.
As a bond’s maturity date approaches, the influence of market interest rates becomes less important. On the maturity date, the government or company that sold the bond to borrow money must repay the debt by giving the bond holder the face value. Let’s say you own a bond that pays a coupon rate far below current market interest rates. To sell the bond, you’d have to discount the price. But if all you have to do is wait a few months to receive the full face value, you won’t sell at a discount. Neither would you buy a bond at a premium price when it’s close to maturity, because there wouldn't be enough time for the interest you’d earn to make up the price difference. In a nutshell, as a bond approaches maturity, the price approaches the face value, no matter what market interest rates happen to be.
Although market interest rates have the most influence on bond prices and yields, another factor is also important: risk. Suppose a bond was issued with a rating of “AAA” by Moody’s and other rating services -- meaning the government or company is a very good credit risk. Then economic problems hurt the issuer’s credit, and the bond is downgraded to “A.” You might still buy the bond – “A” isn’t all that bad. But you'll want a higher interest rate to offset the added risk. As a result, you won’t pay as much for the bond. Since most investors react the same way, the bond price falls, and the yield consequently increases.