As interest rates rise, bond prices drop. Conversely, as interest rates decline, bond prices rise. Interest rate movements reflect the value of money or safety of investment at a given time. The movement of interest rates affects the price of bonds because the coupon rate of interest, the money the issuer pays semi-annually to the owners of its bonds, remains fixed until the bond matures and pays the $1,000 principal. The fixed semi-annual interest payments and the fixed repayment of principal at maturity are why bonds are called fixed income investments.
When a bond is issued, it is given a coupon rate of interest that stays the same throughout the life of the bond. It signifies the amount of interest you receive every year, paid semi-annually. If a bond coupon is 2.625 percent on a bond that matures on August 15, 2020, every February 15 and August 15 it will pay the owner $13.13 in interest or a total of $26.25 for the full year.
Economic conditions and crisis situations cause interest rates to fluctuate. In the event of a terrorist attack or economic crisis, investors flock to bonds as a safe haven for their money. The demand drives interest rates down because, in a flight to quality, investors accept very low rates in exchange for safety of principal. When the economy is prosperous, there is a lot of demand for money and bonds must pay high interest rates to attract investment. Interest rates also rise to keep pace with inflation, and the Federal Reserve may increase or decrease interest rates as part of its management of our economic system.
When interest rates rise to 3.25 percent in the 10 year maturity area, the price of a bond with a 2.625 percent coupon will be $950 per $1,000 face value bond. If interest rates decline to 1.5 percent, the price will rise to $1,100 per bond in the marketplace.
The longer the maturity on a bond, the greater effect interest rate fluctuations will have on the price of the bond. A high coupon intermediate (three to 10 years) or short (one to three years) maturity bond is considered defensive against interest rate risk. A high coupon historically is 9 percent or higher, or at least four points higher than the current market rate.
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