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ELI5: Interest Rates & Bond Prices

Investors like to keep a close eye on interest rates, especially those who hold bonds. The two are closely related. When one goes down, the other goes up. This can cause some confusion. Shouldn't higher rates mean more valuable bonds? 

New bonds are issued all the time. It can be weekly, monthly, quarterly - depends on the issuer. 

Bonds are essentially loans to companies and governments, where in return investors are paid interest at a fixed rate. If rates rise, bonds issued prior to the hike will provide a lower return than their newer counterparts - becoming less valuable. When rates drop, old bonds will provide a higher return - becoming more valuable. 

Let's say you purchased a 10-year bond with a par value of $1,000 and an interest rate of 4%, this equals to a return of $40 a year.

If interest rates rise to 5%, new bonds will be paying investors $50 a year. 20% more than what your bond pays. 

If you want to sell your bond, it'll be impossible to sell it for the $1000 you've paid. Things have changed. The market now demands a higher return. Seeing that you can't increase the rate of your bond, you'll need to discount the price to make up for the lower returns. The new value of your bond would be $922.78. 

The opposite is also true. If interest rates instead dropped to 3%, you now hold a bond that pays more than the current rate. Meaning you can charge a premium. Your bond will be now be worth $1,085.30.


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