What are the effects of interest rate on bond value?
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When you buy a bond, either directly or through a mutual fund, you're lending money to the bond's issuer, who promises to pay you back the principal (or par value) when the loan is due (on the bond's maturity date). In the meantime, the issuer also promises to pay you periodic interest payments to compensate you for the use of your money. The rate at which the issuer pays you—the bond's stated interest rate or coupon rate—is generally fixed at issuance.
An inverse relationship
When new bonds are issued, they typically carry coupon rates at or close to the prevailing market interest rate. Interest rates and bond prices have an inverse relationship; so when one goes up, the other goes down. The question is: How does the prevailing market interest rate affect the value of a bond you already own or a bond you want to buy from or sell to someone else? The answer lies in the concept of opportunity cost.
Investors constantly compare the returns on their current investments to what they could get elsewhere in the market. As market interest rates change, a bond's coupon rate—which, remember, is fixed—becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself. Let's look at an example.
Suppose the ABC Company offers a new issue of bonds carrying a 7% coupon. This means it would pay you $70 a year in interest. After evaluating your investment alternatives, you decide this is a good deal, so you purchase a bond at its par value: $1,000.1
An inverse relationship
When new bonds are issued, they typically carry coupon rates at or close to the prevailing market interest rate. Interest rates and bond prices have an inverse relationship; so when one goes up, the other goes down. The question is: How does the prevailing market interest rate affect the value of a bond you already own or a bond you want to buy from or sell to someone else? The answer lies in the concept of opportunity cost.
Investors constantly compare the returns on their current investments to what they could get elsewhere in the market. As market interest rates change, a bond's coupon rate—which, remember, is fixed—becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself. Let's look at an example.
Suppose the ABC Company offers a new issue of bonds carrying a 7% coupon. This means it would pay you $70 a year in interest. After evaluating your investment alternatives, you decide this is a good deal, so you purchase a bond at its par value: $1,000.1
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