When Interest Rates Go Up Bond Prices Fall

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.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 18 comments
  • Sean

    Thanks Preet, this is a better explanation than the one offered in Chapter 1 of The Four Pillars of Investing!

  • Preet

    @Sean – now THAT is a compliment! Check’s in the mail… ;)

  • Canadian Capitalist

    Preet: Do you have the source for Canadian bond market being 30 times the size of the stock market? According to Triumph of the Optimists the Canadian stock market was worth $801 billion (US) in 2000, compared to the bond market at $539 billion. I doubt that things have changed very much since then.

  • Preet

    Hi CC, I’m curious as to where they get that figure since even only the public debt of Canada was just under $800 billion (all three levels of government) in 2000 according to the study below. While the government’s debt has come down from those levels, I suspect corporate debt has risen due to favourable interest rates.

    http://www.fraserinstitute.org/Commerce.Web/publication_details.aspx?pubID=2826

    However, I was trying to look up some concrete sources for the statistics since I’ve seen 20-30x thrown around various times. There seems to be a bit of a disparity in what I’ve seen, for example:

    http://dsp-psd.tpsgc.gc.ca/Collection-R/LoPBdP/BP/bp418-e.htm (do a search for ‘3.6 trillion’)

    This report claims that back in 1996, the debt markets were 13 times the size of the equity markets.

    http://www.canada.com/theprovince/news/money/story.html?id=0c0665e4-bd11-4556-851a-7996d5473d56 …claims the debt secondary market is 30 times greater than the Canadian equity “trading” market (although no source cited).

    From the looks of it, more accurate would be to say that the fixed-income trading market is 20 (or whatever) times larger than the Canadian equity trading market. I’ll amend the post to reflect that wording – thanks for pointing that out.

  • Canadian Capitalist

    I think an order of magnitude is still an exaggeration. It may also be an impossibility. The total Canadian stock market capitalization is approx. $2T. 20 times would make the bond market $40T but the total size of the world bond market is estimated by various sources* to be $45T. Its incredible that the rest of the world put together has a bond market that is only $5T.

    *http://en.wikipedia.org/wiki/Bond_market#cite_note-US_bond_mkt_debt-0
    *The Intelligent Portfolio

  • Preet

    I understand your point – in that you are referring to market cap, but I am referring to trading volume. Does that address your concern, or are you also referring to trading volume? I agree that on market cap there is not an order of magnitude difference.

  • Canadian Capitalist

    Ah, I don’t have any data about the trading volume. In fact, reading the sources again, even the Province article might be talking about the total dollar value of trades every year.

  • Margie Martin

    Wow! Help for my Finance Courses. Thanks so much… This is great information to do a term paper with….

    Thanks

  • Jonduk

    Is that mean If I buy 30 yr govt bonds when interest rate at all time low, I over paid? If the Federal Bank decided to increase interest rate for the next few months, my bonds will lost it value?

  • Preet

    @Jonduk – saying that you “overpaid” is probably not the precise term to use. If you got the bond at the market rate, then this is the fair price for that point in time based on the overall opinion of the market (doesn’t mean that the market is right, but it doesn’t mean you overpaid either). If interest rates go up, then yes, your 30 year bond would fall in price, but note that if you just held the bond to maturity you would get all the interest payments (and return of principal) that you bargained for. A lot of people think interest rates will go up in the future, and this should be priced into the market as well. A lot of people are keeping their bond durations short while they wait for interest rates to increase before extending maturities… but you should discuss your personal strategy with your own qualified financial advisor.

    Thanks for stopping by!

  • JasonT

    ” 8% divided by $70 = Better price to pay for the bond = $875.”

    Should read,

    $70 divided by 8% = Better price to pay for the bond = $875.

  • Preet

    @JasonT – thanks for the correction! Post has been amended to read “8% divided INTO $70″. Cheers!

  • PANKAJ JOSHI

    thanks bro.
    it was too simple & easy to understand.

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