- Interest rates and bond prices have an inverse relationship. Rising interest rates result in lower bond prices and declining rates will cause bond prices to increase. Most bonds pay a fixed rate of interest and when the current market rate for similar bonds is different than the rate paid by a bond, the price changes to bring the yield in line with current rates. The prices of bonds are described as being at a discount or premium to the bond's face value. The discount or premium will be accounted for in a bond's quoted yield to maturity.
- Changing interest rates have a limited effect on the value of shorter term bonds. At maturity, the face value of a bond is paid to an investor and the short time frame until that amount is paid limits the price volatility of shorter term bonds. Consider a $10,000 bond with a 6 percent coupon yield and two years to mature. Interest rates rise from 6 percent to 6.5 percent. The price of the bond will fall from $10,000 to $9,909, a 0.91 percent drop.
- Bonds with more years to go until maturity will show a higher level of volatility in response to changing interest rates. If the example bond from above matures in 20 years instead of two years, the price will decline to $9,450 with the half-percent rate increase. The percentage of change increases to 5.5 percent or almost a full year's interest earnings due to the higher rate. If market rates decreased to 5.5 percent, the bond price would go up to approximately $10,600; a 6 percent increase in value.
- If interest rates are expected to increase, investors want to own shorter term bonds. The short term bonds will retain more value and the principal value of the bond will pay off soon and can be reinvested at the new, higher rates. In a falling interest environment, long term bonds lock in the current higher rates and higher bond prices can result in additional capital gains. These strategies can be used when selecting bond mutual funds or exchange traded funds as well as when investing in individual bonds.
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