Why do the bond prices decline when interest rates rise?
It is not uncommon to read about bond prices rising when interest rates are declining and vice versa. But what is the major reason behind these changes?
To put in a better way, how and why bond prices change when interest rates rise?
To answer this, let’s imagine that Mr.X purchases a bond for $ 1,000.The bond matures in four years. The coupon rate of the bond is 5%. Therefore, it pays $ 50 a year in interest.
After one year, interest rates rise to 6% and Mr. X decides to sell his bond as he urgently requires his initially invested $ 1000.
Once he places an order to sell his bond, his order would enter the market and interested buyers would compare this particular bond with the other bonds in the market at that particular point in time.
Since the interest rates must have gone up in the market after one year, a newly issued $ 1000 bond with a maturity period of 4years (the time left for the bond from Mr.X to get matured) would be introduced in the market by then that would be paying the interest of 6%.
This accounts to $ 60 a year.
Interestingly, if an investor purchases bond from Mr.X for $ 1000 he would receive $ 50 * 4 or $ 200 in interest over the remaining four years.
And, if the same investor purchases a new bond for $ 1000 he would receive $ 60 * 4 or $ 240 in interest over the remaining four years.
In sort, there is no enticement for the investor to buy bond of Mr.X at the face value of $ 1000 when he could make more profit after purchasing the new bond with increased interest rate at same par value. Therefore, in such circumstances Mr.X has to sell his bond at a discount to make it look more attractive.
He should sell it at around $ 960 to make it look more attractive. The investor would now receive $ 200 interest in addition to $ 40 of principal when the bond matures. As investor has to pay less for the bond he would receive same profit over same maturity period similar to a newly issued bond paying much higher interest rate.
Therefore, bond prices have to go down to adjust for any rise in interest rates in the market.