Interest rates and bond prices: Whats the connection?

You have been hearing about the rise in the US interest rates leading to a fall in bond prices.If you are not well-versed with how the debt market works, you must be wondering why bond prices fall when interest rates rise. So, let us try to understand why bond prices are inversely related to interest rates with the following example.

You buy a 10-year, Rs 1,000 bond with interest rate (also called the ‘coupon rate’) of say, 7%. You will earn simple interest of Rs 70 per annum on this bond.After one year, if the interest rate increases to 8% and if you now wish to sell the bond, it will not be possible for you to sell it at Rs 1,000.This is because a buyer can now buy a new bond of Rs 1,000 in the market that offers higher interest rate of 8%. Since the interest rate is fixed for the entire duration of the bond (unless the bond offers a floating rate of interest), the only way to sell the bond with a coupon rate of 7% is to offer the bond at a discount to the face value of Rs 1,000. The amount of discount will be such that the return on investment for the buyer would be close to 8%. In the above example, since the interest to be earned on the bond is fixed at Rs 70 per annum, the price of Rs 1,000 bond will have to be Rs 875 to offer the buyer a return of 8% on his investment. So, the bond will have to be sold at a discount of Rs 125.

In the event of a fall in interest rate, the price of your bond will rise to match the lower return offered by new bonds offering lower coupon rate. So, if the interest rate declines to 6%, but your bond is offering interest rate of 7%, the price of your bond appreciates commensurately to match the lower return on investment. The price of your Rs 1,000 bond will increase to around Rs 1,168, so that the new investor will get a return that is equivalent to the return offered by new a bond offering interest rate of 6%. The fall in interest rate has, therefore, fetched you a premium of Rs 168 on your principal amount.

In the above example, if you choose to hold the bond till the time of maturity, instead of selling it in the bond market, you will keep getting interest of Rs 70 per annum and your principal amount of Rs 1,000 will be refunded to you upon maturity.