Bonds aren’t as sexy as stocks so they don’t get as much attention, but did you know that the Canadian fixed income market trading is roughly 30 times the size of the Canadian stock market trading? (See the comments section below for more discussion on this asssertion.)
If you’ve been reading up on investing, eventually you will have come across the relationship between bond prices and interest rates – namely that when interest rates rise, bond prices fall (and vice versa). Why is that? Well, first lets go over the basics of a bond.
Let’s say we have a company that needs to borrow $10 million to build a factory. If the Government interest rates are 5% (just an example), then that company might offer to pay 7% interest on $10 million worth of 10 year bonds. They offer more than 5% because unlike the Government, there is a chance that company will go out of business and not be able to pay it’s obligations – you know, the ol’ risk and return trade-off.
It’s 2008 and they successfully issue these bonds into the market. Now these bonds can be traded between investors on the bond market – the company doesn’t care who owns them, they just have to pay their interest payments on time to whoever holds those bonds at the time of the interest payment.
The bonds have a price that gets quoted which is based on a par value of 100. So, even though most bond issues are denominated in $1,000′s, they are priced in 100′s. The par value is what the bonds will pay on maturity. So if you hold your 10 year bond for 10 years, the company has agreed to give you $1,000 per bond you own, and they have issued a total of 10,000 bonds. The price of the bond can fluctuate just like a stock in that it is based on supply and demand. Further, if the bond pays 7%, that means that for every $1,000 bond you own you would receive $70/year.
So why do bond prices fall when interest rates go up?
Well, let’s say that the Government raises interest rates to 6% in 2009 (up from 5% in 2008). Think of this as the new ‘going rate’ for debt. If we had an identical company that decided to issue bonds now, then they might have to pay 8% in order to find buyers for their bonds.
If you were an investor, would you rather earn 7% or 8% per year on a bond that is tied to companies of equal credit risk? Of course you would choose to earn 8%. So it would make no sense to buy the bond that has an interest payment of $70…
…unless you offered to buy it for less money.
If you just calculate how much money would need to be invested at 8% (the higher rate) to earn $70/year in interest payments (remember once a bond is issued, it’s interest payment per bond does not change even though the price can fluctuate) you can figure out how much you would offer for the 7% bond to get an 8% yield.
The calculation is simple: 8% divided into $70 = Better price to pay for the bond = $875. Another way of looking at it is that a $70 annual interest payment on $875 is an 8% yield. So from an investors’ perspective, that bond which may have been trading at 100.00, should be closer to 87.50.
Now, there is more to bond pricing that just this, but this is the basic reasoning why bond prices move inversely to interest rates.