Interest Rates Vs. Bond Prices: How Do Bonds Work?

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There is an inverse relationship between bond prices and interest rates. This is all a matter of supply and demand. And, if you understand the inverse relationship then you will better understand the way interest rates move.

What Is A Bond?

Bonds are debt instruments. There are two basic types of debt instruments, notes and bonds. The difference between the two is nothing more than the length of time associated with the debt. Anything up to 10 years is a note and anything beyond 10 years is a bond. As for U.S. government debt the instruments are largely the same. These instruments may also be expressed as bills because essentially they are bills that need to be paid by the United States government. These bills may be denoted in various dollar amounts.

How Bonds Get Distributed?

To begin with, you cannot purchase a bond directly from the United States government, but need to go through an intermediary such as JP Morgan, Wells Fargo or another broker dealer bank. The major banks bid up to 30 days in advance of the Treasury auction to buy the bills. These bills are then dispensed to the various customers and second tier banks partnered with the major banks. Through those avenues the general public can buy bonds.

How Do Bonds Work?

Let us say you want to lend the United States government $1,000.00 for a period of 10 years. You would go to your local bank and purchase the note from the bank. You would pay $1,000.00 for that note, the face value of the bill. In exchange, you will have an agreed upon interest rate that the government will pay to you annually as well as the term of the note, in this case the 10 years.

If the interest rate is 3%, in this example, and on an annual basis, you would collect $30.00 from the government in interest fees. This will go on and on for the entire duration of the 10 years agreed upon when it was purchased; you would collect $300.00 in total interest payments. Then, after the 10 years, the government will give you back your initial $1,000.00 that you lent to them.

But, if interest rates are to fall, or head higher, then the mathematics on that bond change.

Interest Rates Vs. Bond Prices

I mentioned in the very beginning of this article that bond prices and interest rates are inversely related. In the above example, the coupon for the bond is set at 3%. That is set. But, if interest rates were to fall, the bond’s price would increase as it became more valuable, since the bond contract is fixed at a higher interest rate than is now available in the market.

In that example, if, after one year, interest rates were to fall to 2% then the price of the bond would rise. The face value of the bond is no longer $1,000.00 but instead the price may rise to $1,082.00. This is the inverse relationship. Effectively, if you were to sell the bond the person who bought the bond would buy the face value of the bond and receive the agreed upon interest rate. However, since market interest rates have moved than the price that the individual bond costs would move upward. 3% on a $1,000.00 bond yields $30.00 in interest payment after one year. But, 3% on a bond that cost $1,082.00 would be 2% in yield. The face value of the bond would stay the same at $1,000.00, meaning that in 10 years (using the same example) the government would only pay you $1,000 regardless of the bond price at that time and regardless of the price that you pay for it.

If the opposite were to occur and market interest rates moved higher then the value of your bond would decline, as the market interest rate is now higher than what your bond pays. While the face value of the bond always stays $1,000 the value (price) of the bond would decline to approximately $918.00. Then, with a $40.00 yield (the 4% market rate), the bond would return the 3% yield on the original $1,000.00 face value.

What Is An Interest Rate?

Here is an excerpt from an article discussing the economic business cycle, which is paramount to this discussion, and the function of interest rates:

People can either decide to consume today by way of funding this consumption through either savings or debt, or they can invest the capital today and hold off consumption until a time in the future…

The money allocated by people for investment into the economy makes up the funds available for lending (called loanable funds). Entrepreneurs or businesses in the economy usually demand to borrow those funds in order to obtain capital for purposes of investing.  The lending happens at the market rate, also called the interest rate, which is the equilibrium point where the supply of funds and demand for them meet, taking into consideration the current risk level of lending and the investment itself.

The greater availability of funds for investment, the lower the lending rate is, thus making the cost of capital cheaper for a business, thus making it easier to manage the debt and less costly, helping to grow the economy faster.

The Federal Reserve controls the rate of interest that it pays to its member banks for holding their reserves, as well as the rate at which member banks lend to one another. By controlling the interest rates throughout the economy this ultimately affects all consumers, businesses and investors and foreign governments.

Here it is in the Federal Reserve’s own words:

Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.

In theory, if the economy is experiencing rapid inflation in excess of established targets then the Federal Reserve would increase the interest rate, thereby increasing the cost of lending and reducing your ability to purchase a car, home or anything else on credit as it becomes more costly for you.

For example, if a new car costs $25,000.00 to purchase with 60 monthly payments and interest rates are at 5%, the monthly loan payment is $472.00. But, at 6% that same loan will go up to $483.00 monthly.

That may not seem like a lot for any one individual, but there are some 17.6 million vehicles sold in the United States annually. If you added $132.00 ($11 x 12 months) to every car sold in America that is $2.3 billion annually in costs that are not helping the economy grow, but merely the cost of servicing debt. Imagine what rising interest rates would do to the whole economy? You can read an in-depth discussion of how debt affects you here.

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