Bonds are debt securities issued by corporations, government agencies and municipalities. When an organization issues a bond, in most cases the company agrees to pay the bond holder a fixed interest rate for the duration. The price investors desire to pay for a bond is directly affected by market interest rates. Bonds and interest rates carry an inverse relationship, meaning the price of bonds and interest rates flow in opposite directions. Understanding bonds’ sensitivity to interest rates can help you know the best time to invest in bonds.
The rate of interest the bond issuer agrees to pay the bond holder until the bond’s maturity is the coupon rate of a bond. The coupon rate is not affected by changes in the market interest rate. Investors can research the coupon rate of a bond before buying it. A bond with a face value of $1,000 and a coupon rate of 8 percent pays an investor $80 annually in interest payments for the life of the bond. In most cases, the coupon rate and the prevailing market interest rate are the same or close to one another.
When Interest Rates Rise
The market rate is the current interest rate prevailing in the market at a given time. An increase in the market rate can occur for several reasons, but one primary reason is when investors believe inflation is on the horizon. When market interest rates rise, the price of a bond falls and bonds sell at a discount. For example, if you bought a $1,000 bond with an 8-percent coupon rate during a time when the market rate was 8 percent, you receive $80 in interest payments every year. If the market rate increases to 10 percent, bonds issued by companies are likely with 10 percent coupon rates. This means that investors can earn $100 in interest payments, so little reason exists for them to buy your bonds, offering only $80 in interest payments. For investors to buy your bond, you must offer it at $800 ($80/.10), which is at a discount of $1,000.
When Interest Rates Fall
The opposite effect occurs when market rates fall. The value of a bond increases when market rates decline. During times of recession or when the economy is growing slowly, markets rates typically decline. If the market rate declines from 8 percent to 7 percent for a $1,000 bond, you can sell the bond for $1,142.86 ($80/.07). The bond must sell at this premium to remain competitive with newly issued bonds and offer investors a 7 percent yield.
Credit rating agencies provide ratings for bonds based on the financial health of the company issuing the bond. A bond rated as risky offers a higher coupon rate than a bond with a good credit rating. Junk bonds, which are the riskiest bonds, typically pay high coupon rates. However, the company issuing junk bonds has a higher chance of defaulting on the repayment of its bonds than a company with a high credit rating. The type of bond purchased depends on the risk tolerance of the investor. Some investors do not mind carrying the extra risk because of the chance of receiving interest payments much higher than what the prevailing market rate allows.