How do interest rates affect bond prices?

It may seem strange at first but interest rates and bond prices move in the opposite direction, impacting the market value of investments.

Each month the Reserve Bank of Australia meets to discuss ‘monetary policy’ centred on whether to maintain or alter the official cash rate, the key benchmark for interest rates.

The cash rate went from above 7% in 2008 to 2.5% in 2013, with a few ups and downs along the way.

Changing interest rates and the expectations about the future direction of interest rates are probably the biggest single influence on the market price of bonds.

What happens when interest rates go up?

When interest rates rise, the market value of bonds falls.

If you have a bond with a coupon of 3% and the cash rate increases from 3% to 4%, for example, the coupon rate on the bond will now seem less attractive to investors so they’ll be willing to pay less for it.

The market price of long term bonds may be more volatile than shorter term bonds, because changes to the relative rate of return would have a bigger impact over a longer period of time.

A lower price, however, would improve the current yield for perspective investors because if they can buy the bond for a discount, their overall return will be higher.

  • Floating rate bondholders stand to benefit from an increase in interest rates because the coupon rises or falls in tandem with interest rates.

What happens when interest rates go down?

If interest rates decline, bond prices will rise. That’s because more people will want to buy bonds that are already on the market because the coupon rate will be higher than on similar bonds about to be issued, which will be influenced by current interest rates.

If you have a bond with a coupon rate of 3% and the cash rate falls from 3% to 2%, for example, then you and other investors might wish to hold onto the bond as the rate of interest has improved on a relative basis.

A rise in demand will push the market price of the bonds higher and bondholders might be able to sell their bonds for a price higher than their face value of $100.

  • Floating rate bondholders would lose out from a fall in interest rates because the coupon rises or falls in tandem with interest rates.

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