Bonds and Interest Rates

Bond prices tend to move in the opposite direction of interest rates. If prevailing interest rates rise, bond prices fall; conversely, if rates fall, bond prices rise.

Here is why that happens. Bonds are usually issued in increments of $1000 which is known as the face value of the bond. The bond carries a stated interest rate, or coupon rate, which is the amount of interest that will be paid to you by the bond issuer every year until the bond comes due on the maturity date.

Think of it this way: five years ago, you lent your brother $1000 for 10 years. You and he agreed that he’d pay you 5% interest each year, or $50 dollars (5% of $1000) for allowing him to use your money and, at the end of the ten years, he’ll give you your original $1000 back. Your brother signed a promissory note, which you hold, detailing the agreed upon terms, including face value ($1000), maturity date (6/08/2010) and coupon interest rate (5%). Every 6 months he pays you $25 or one-half of the annual interest and, if all goes well, he’ll pay you $1000 on June 8, 2010.

When a corporation needs to borrow money, one way it does so is by selling bonds to investors. XYZ Corp. takes your money and issues you a bond which is just like the promissory note issued by your brother. XYZ uses the money for its purposes and, in exchange, it agrees to pay you interest and give you all your money back when the bond comes due.

Easy so far? Well, here’s where it gets a little bit tricky. Your bond, unlike your brother’s promissory note, is “marked to the market.” Simply put, that means its market value fluctuates and you’ll see that fluctuating price on your brokerage statements each month. Remember, the face value never changes and you are assured of getting your $10,000 back at maturity, (except in cases of bankruptcy), no matter what happens to the market value between now and then.

As an example, let’s say that five years ago, you had $10,000 earmarked for bonds. You were convinced that XYZ Corp was creditworthy so you bought ten of the XYZ Corp 5% due 06/08/2010. You’ve been getting your $500 per year (5% of $10,000) and it’s been be paid to you in two installments of $250 each, every 6 months on December 8^th and June 8^th.

Let’s say that today’s interest rates are closer to 4% and that, after holding the bond for several years, you need to sell it because you need the money for other things. The bond doesn’t come due for five more years so you’ll have to sell your bond to another investor. Others should be interested in buying the bond from you since its carries a 5% coupon rate and new five year bonds are being issued with a 4% coupon. If someone buys the bond from you, they’ll get the $500 interest payment each year.

What will they pay for your bond? You may get as much as $10,450 for the same bond you bought for $10,000.

Here’s how the math works. With prevailing rates in our example at 4%, a new buyer finds value in paying you any amount less than $10,450. The $500 annual interest payment the buyer gets each year $100 more than current rates. Since the bond is now a five year bond the buyer recievces an additional $100 for five years. The bond pricing formula takes into consideration the time value of money, pricing the bod at 104.50 rather than 105 even.

Of course, the inverse would be true as well. If prevailing rates were higher when you bought your bond then they are at the time you try to sell it, then you’ll get less for your bond than you paid for it. Let’s say prevailing rates are now 6%. A buyer’s breakeven would then be $9575 and she would be willing to pay you only that much or less for your bond with a 5% coupon.

Susan

Remember, this blog is unedited so don’t bust me on the grammar or spelling.