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 Bond Values and Interest Rates

Many people are confused about the relation between interest rates and the market value of bonds.  For the long-term investor who can hold his bonds to maturity, that doesn’t matter very much.  But if he may have to sell before maturity, it is important that he understand how the market value of his bond is affected by changes in interest rates.

Buying a Bond

Suppose you bought a newly-issued 10-year bond at par for \$1,000 that pays interest at 6%.  You would receive \$60 per year in two payments of \$30 each.  The interest payment is known as the coupon, a holdover from the days when paper bonds were issued with coupons attached.  The bearer would clip off a coupon as it came due and present it to the borrower to claim the interest payment.  When the bond matured, the principal part would be returned to claim the par value of the bond, thereby ending the borrower’s liability.

The coupon rate on a new-issue bond is governed by the yield on bonds of the same maturity in the secondary market at the time.  Why?  Because the borrower must offer a coupon rate that is at least equal to the yield on existing bonds, otherwise there would be no takers.

Yield on the Bond

The term "yield" is shorthand for the yield-to-maturity which takes into account any difference between what is paid for the bond and its value at maturity.  The yield on a new bond bought at par is normally the same as the coupon rate.  Thereafter, as the general level of interest rates changes, the value of the bond in the secondary market will move in the opposite direction.

What matters to the buyer is the yield, which is a reflection of the prevailing interest rate.  The coupon rate is set when the bond is issued.  If the general interest rate then falls below the coupon rate, the bond will command a premium because its yield at par would be higher than the prevailing interest rate.  The converse also applies.

Effect of a Change in Market Interest Rates

Suppose after two years, the interest rate on bonds of 8-year maturity is 5%.  Since that is less than the 6% coupon rate on your  bond which now has 8-years to maturity, its market value would be higher than the \$1,000 price you paid.  In fact it would be \$1,065.

If you sold the bond at that price, you would realize a capital gain of \$65.  The return on your investment would therefore be greater than the 6% you expected when you bought the bond.  But if you then reinvested the proceeds in another bond of 8-year maturity, the yield would be only about 5%, the going rate on bonds at the time.

The buyer of your bond would receive the coupon payments of \$60 per year.  If he held the bond to maturity, he would receive the face value, \$1,000, as promised by the borrower.  That means he would have taken a capital loss of \$65, the equivalent of about one year of coupon payments.  However he would have enjoyed a coupon rate that is higher than the yield on existing bonds of that maturity.  The net effect is that his total return would be about 5%, the going rate on bonds at the time.