What causes bond price to change

The bond price fluctuates due to two primary reasons: everyday change in the interest rates and the credit quality of the bond.

Bond price and interest rates:

In the bond world, the interest rate is seen as a risk and are referred to as ‘Interest rate risk’ or ‘Market Risk’.

The fundamental principle is that the interest rates and prices have an inverse relationship. To elaborate on that, if interest rates increase then the price of the bond falls and vice versa.

Scenario One: Interest rates increased

Let’s say you are buying a bond with 30-year maturity with a face of $1,000 and a yield of 4%. Now you want to sell the bond say after a year. You start to look for similar bonds in the market and you find that similar bonds have a yield of 8%.

Now, do you think the investors will buy bonds with low yield (8% > 4%) when the bond characteristics are the same? NO.

How to sell the bond when the interest rates have been increased? Now, from our principle, we know that if interest rates increase then the price will go down.

Let’s do some basic math to determine the price.

Current     : 30 YR maturity, 8% yield, $ 1,000.

Your bond: 30 YR maturity, 4% yield, what should be the value?

4000 = 8X

X = $ 500

X determines what should be the price. This is also called the bond markdown.

Scenario Two: Interest rates decreased

Let’s say you are buying a bond with 30-year maturity with a face of $1,000 and a yield of 4%. Now you want to sell the bond say after a year. You start to look for similar bonds in the market and you find that similar bonds have a yield of 3%.

Now, do you think the investors will buy bonds with high yield (4% > 3%) when the bond characteristics are the same? YES.

How to sell the bond when the interest rates have been decreased? From our principle, we know that if interest rates decrease then the price will go up.

Let’s do some basic math to determine the price.

Current     : 30 YR maturity, 3% yield, $ 1,000.

Your bond: 30 YR maturity, 4% yield, what should be the value?

4000 = 3X

X = $ 1,333.33

X determines what should be the price. This is also called the bond markup.

From our two possible cases, we can see how market changes will help benefit the investor. This is the most fundamental risk caused by market volatility which an investor should handle.

Note: An investor is free from interest rate risk if they chose to hold the bond to maturity. Why? The principal and coupon payments aren’t affected by market volatility.

Bond price and credit ratings:

The credit rating of a bond indicates the likelihood of default (will you get your principal at end of maturity and receiving your timely coupon payments).

There are also other ways of determining the bond price. Another popular way to understand is using Yield To Maturity.

For checking interest rates on US Treasury Bonds, check the treasury website.

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