Understanding why Bond prices fall when Interest rates go up
Say I bought a laptop for Rs 1 lac – the latest model. One month later my friend gets a better model with more features for Rs 1 lac
I go back to the shop from where I had purchased the laptop to complain saying that the deal was unfair for me. To my surprise I realize that the same laptop which I had purchased a month back for Rs 1 lac is now retailing at Rs 95, 000
Now why did this happen?
Clearly, two things happened. 1) The manufacturer first sweetens the offer adds some new features at the same price. 2) Therefore he gives a discount on the earlier model and brings down its price from Rs 1 lac. to Rs 95, 000 In a manner of speaking we can then say that the moment the market makes a BETTER or HIGHER offer at the same price, the price of the older version goes down.
In the same manner when the market offers BETTER or HIGHER interest rates, then the PRICE of OLDER VERSION of bonds with lower interest rates comes DOWN.
Similarly when interest rates are expected to come down, prices bonds yielding higher interest rates would climb up. This can be compared to a scenario when a manufacturer of a car strips down some of its features in order to maintain prices. In such a case the original model would be priced at higher price
Let’s understand this with a numerical example: - A bond is issued for Rs. 10, 000 for five years with a 5% coupon or interest rate, paid every six months. Then interest rates in the market rises to 6%. If you want to sell this bond, who would buy it when it is paying 1% below market rates (5% vs. 6%)? You have to sweeten the deal so that the buyer gets at least market rate for the bond. You can’t change the interest rate on the bond. That’s fixed at 5%. You can, however change the price you will take for the bond.
Let’s understand this with a numerical example: - The annual payment of Rs. 500 (Rs. 10, 000 x 5%) must equal a 6% payment. Doing the math, you discover that the face value of the bond must be discounted to Rs. 8, 333/- so that the Rs. 500 fixed payment equals a 6% yield on the buyer’s investment (Rs. 8, 333 x 6% = Rs. 500). If interest rates went down instead of up, you could then sell your bond at a premium over face value because the fixed interest rate would be higher than the market rate
Hope this story has clarified why one should invest in long duration bonds when interest rates are expected to fall and short duration funds when interest rates are expected to rise Please give us your feedback at professor@tataamc. com The views expressed above are for information purpose only and do not construe to be any investment, legal or taxation advice. Any action taken by you on the basis of the information contained herein is your responsibility alone and Tata Mutual Fund will not be liable in any manner for the consequences of such action taken by you. Please consult your Financial/Investment Adviser before investing. Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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