Interest Rates & Bond Prices

Introduction to Interest Rates and Bond Prices 

Interest rates play a crucial role in the bond market, directly affecting bond prices and yields. 

Melvin, a bond investor, notices that his bond portfolio's value has decreased following recent interest rate hikes. 

Confused by this decline despite holding the same bonds, he wants to understand how changes in market interest rates impact his investments. 

This lesson explores the inverse relationship between interest rates and bond prices, helping investors like Melvin make informed decisions.

How Bonds are Priced 

Bonds are priced based on the present value of their future cash flows, including regular interest payments and principal repayment at maturity. 

Investors discount these cash flows using the current market interest rate.

When interest rates rise, the discount rate increases, lowering the bond’s present value and price.

Conversely, when rates fall, the discount rate decreases, raising the bond’s price. 

This discounted cash flow (DCF) approach explains how interest rates directly impact bond valuations.

The Inverse Relationship Explained 

Bond prices and interest rates move inversely. 

When interest rates rise, the discount rate in bond pricing increases, reducing the bond's present value and price. 

Additionally, new bonds offer higher coupons, making existing lower-coupon bonds less attractive, decreasing their demand and price. 

Conversely, when interest rates fall, the discount rate decreases, increasing bond prices. 

Lower rates make existing higher-coupon bonds more appealing, boosting their demand and value.

Melvin Notices the Impact of Rate Hikes 

Melvin holds a 10-year, $1,000 SafeBank Corp. bond with a 3% annual coupon, bought at par two years ago. 

After the central bank raises interest rates by 1%, new bonds are issued at 4%. 

Checking his account, Melvin sees his bond's price has dropped to $950. 

Surprised by this $50 decline despite SafeBank's stability, he realizes investors prefer new, higher-yielding bonds. 

Melvin seeks to understand how rising interest rates have reduced his bond's market value.