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 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.

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

There is an inverse relationship between interest rates and bond prices. If rates increase, bond prices decrease. All else the same, there is an inverse relationship between the coupon rate and interest rate risk. A bond with a lower coupon has more interest rate risk than a bond with a higher coupon.

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

Answer and Explanation:

Economic investments by firms into their capital are financed using borrowed money. If the rate of interest goes up, the cost of borrowing goes up. As a result, firms borrow less and, thus, invest less.

Is there an inverse relationship between the value of a bond and its required rate of return? ›

Answer and Explanation:

The value of a bond is directly proportional to the coupon rate while it is inversely proportional to the required rate of return or the market interest rates.

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

Higher interest rates tend to negatively affect earnings and stock prices (often with the exception of the financial sector). Changes in the interest rate tend to impact the stock market quickly but often have a lagged effect on other key economic sectors such as mortgages and auto loans.

What is the inverse relationship between rates and bonds? ›

Bond prices and interest rates have an inverse relationship. When interest rates rise, newly issued bonds offer higher yields, making existing lower-yielding bonds less attractive, which decreases their prices.

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.

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 have an inverse relationship with interest rates? ›

Generally, interest rates and the stock market have an inverse relationship. When interest rates rise, share prices fall. Bonds become more attractive.

What is the relationship between the price of a bond and interest rates direct relationship indirect relationship independent relationship inconclusive relationship? ›

Bond prices and interest rates are inversely related, with increases in interest rates causing a decline in bond prices. Learn why interest rates affect the price of bonds, and how you can take a position on the bond market.

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 is the formula for bond price and interest rate? ›

The bond valuation formula can be represented as: Price = ( Coupon × 1 − ( 1 + r ) − n r ) + Par Value ( 1 + r ) n . The bond value formula can be broken into two parts for better understanding. The first part is the present value of the coupons, and the second part is the discounted value of the par value.

Why do bond prices fall when interest rates rise? ›

What causes bond prices to fall? Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value.

Do stock prices go up when interest rates go down? ›

The bottom line is that interest rate movements can dramatically affect the borrowing costs of large Wall Street firms. By having lower borrowing costs, these companies can improve their profits. As a result, trading institutions tend to push up prices when interest rates and Treasury yields fall.

Why do asset prices fall when interest rates rise? ›

Higher borrowing costs may make it impossible for collateral- constrained natural buyers to fully roll over loans used to buy the asset, and the resulting drop in “cash in the market” necessitates a lower level of the asset price.

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.

Are bond prices and interest rates directly related True or false? ›

Answer and Explanation:

Bond prices and interest rates do not have a positive relation, on the contrary, they are inversely related to each other.

Do interest rates and inflation have an inverse relationship? ›

In theory, inflation and interest rates have an “inverse” relationship: When rates are low, inflation tends to rise. When rates are high, inflation tends to fall.

What does the price of a bond depend on quizlet? ›

The value of a bond depends on the amount of principal, when it matures, and the interest it pays. As interest rates increase, the prices of existing bonds increase. Most bonds pay interest semi-annually.

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