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.
What does the yield curve shape tell you?
If you want to use the yield curve as an investment decision tool, you need to know that yield curves can take different shapes. More importantly, you need to know what each shape represents.
A normal (or upward-sloping) yield curve indicates that interest rates rise as maturities lengthen, i.e. short-term rates are lower than long-term rates. This is the normal type of interest rate environment.
If the yield curve is steep, it means that you can attain significantly increased bond yields (and income) by purchasing bonds with longer maturities. A steep yield curve typically indicates investor expectations for rising inflation and stronger economic growth, and can usually be seen at the beginning of an economic expansion (or after the end of a recession).
If, however, the yield curve is flat, the difference between short-term and long-term interest rates is relatively small. In such a situation, investors may prefer to remain in the short end of the yield curve and purchase bonds with shorter maturities.
An inverted or downward-sloping yield curve implies that the longer the bond's maturity is, the lower the available return will be. It indicates that investors expect interest rates to fall. An inverted yield curve is sometimes considered a sign of an imminent depression.