What is the relationship between bond prices and interest rates?
An inverse relationship exists between bond prices and interest rates. This relationship is typically immediate and predictable. Essentially, when you buy a bond, you are implicitly taking a view that interest rates are likely to stay static or decrease.
If interest rates rise, bond prices will fall; this is because they must be sold at a discount in order for the investor buying the bond to earn the current market rate of interest. Conversely, if interest rates decline, bond prices will rise since the coupon rate will be higher than the prevailing market interest rate.
As an investor in bonds, you should at least be aware of the following two points in relation to interest rate changes:
- bond prices are more sensitive to a reduction in interest rates than to an increase in interest rates
- low coupon bonds are more sensitive to interest rate changes than high coupon bonds.
What is the relationship between interest rates and maturity?
Interest rate changes do not affect all bonds equally. The longer the term to maturity of a bond, the greater the risk that the market price of the bond will fluctuate from the maturity value
In return for taking on the additional risk associated with longer-term bonds, investors expect to receive compensation in the form of increased yield. As a result, there is a direct link between maturity and yield, a link explained by the yield curve.
A yield curve is a graph in which interest rates are plotted against term to maturity for bonds of the same credit quality. Analysts, traders and investors study the shape of the yield curve carefully because it contains built-in expectations about future trends in interest rates.