Bond Price Vs Interest Rate

To understand the differences between bond price vs interest rate, bond price is the amount that an investor pays to buy a bond. If you purchase a bond directly from an issuer, the face value and the price of the bond are the same. However, if you buy a bond through another investor, the bond price might differ from the face value. On the flip side, the interest rate is what the issuer periodically pays to the investor based on the bond's face value. 

Relationship Between Bond Prices Vs Interest Rates

Understanding bond prices and interest rates starts with recognising their inverse relationship. When interest rates rise, bond prices fall. Similarly, when interest rates fall, bond prices rise. 

Consider the following scenario to understand the inverse relationship between bond prices and interest rates. 

Scenario 1:

Suppose you bought a bond at a 5% interest rate. Now, a new bond is issued at a 6% interest rate. Investors will now prefer buying bonds at a 6% interest rate as it will give them a higher return. However, to sell your existing bond, you will have to decrease the price of your bond and sell it at a discounted rate. Thus, bond prices and interest rates have an inverse relationship. 

Scenario 2:

Suppose you bought a bond at a 5% interest rate. Now, the interest rate on the bond falls to 4%. Thus, your existing bond is offering you a higher return compared to the newly issued bond. New investors will be willing to pay a higher price for the existing bond. As a result, you will increase the price of the existing bond. Changes in the interest rate thus affect the price of bonds inversely. 

Why Do Bond Prices Fall When Interest Rates Rise?

A decrease in the interest rate results in a decrease in the value of the related investments. However, the already-issued bonds will not be affected as the same coupon rate continues to apply. Nevertheless, the existing interest or coupon rate is higher than the new interest rate. This will push investors to increase the bond price.

On the other hand, when interest rates increase, the value of related investments will increase.  This implies that the new interest rate is higher than the existing interest rate. As a result, existing investors will sell their existing bonds at a discounted price resulting in a fall in the price of bonds with a rise in interest rates. 

Check out the interest payout options for different bonds on our website now!

How Do Interest Rates Affect Bonds and Their Yields?

Bond yield is the earning of an investor from a bond over a specific tenure, expressed in a percentage. It is dependent on the interest rate and bond price. As a result, when interest rates rise and bond prices are lower than the face value, your bond yield will be higher than the coupon rate.

Similarly, when the interest rate falls, and the bond price is higher than the face value of the bond, your bond yield will be lower than the coupon rate. Consider the examples below to understand how interest rates and bond prices affect bond yield:

Scenario 1:

Bond Tenure: 10 years

Bond Price: ₹5,000

Coupon Amount: ₹200

Yield = (Interest on bond/ price of bond) * 100 = ₹200/₹5,000 * 100 = 4%

Now, if the bond price increases to ₹5,500, the yield will be as follows:

Bond Yield = ₹200/₹5,500 * 100 = 3.64%

Thus, as the price of a bond increases with a decrease in the interest rate, the yield of the bond decreases. 

Scenario 2:

Now, for the same bond priced at ₹5,000, the bond price falls to ₹4,300. The new yield will be as follows:

Yield = ₹200/₹4,300 * 100 = 4.65%

Thus, as the bond price falls due to an increase in the interest rate, the yield increases.

Impact of Inflation on Bond Prices

During inflationary situations, the interest rate of bonds increases. As a result, the price of bonds falls. This decreases the value of your existing bond. A high inflation thus makes fixed-interest bonds less attractive.

In addition, bonds with a longer maturity tenure are more sensitive to fluctuations in the interest rate. Thus, they are more impacted during inflation. An inflationary trend decreases the real rate of returns of fixed-interest bonds leading to a decrease in bond price.

Investors experience a reduced purchasing power from fixed-interest bonds during inflation. As a result, they tend to reinvest their earnings in other investments. This causes a decrease in the price of bonds.

Thus, the inverse relationship between bond price vs interest rate is evident even during inflation in the economy. As the Reserve Bank of India increases the interest rate in the economy during inflation, the bond prices fall.

Explore the yield to maturity of various bonds available on our website!