Why do bond prices fall as interest rates and yields rise? This article explains the basic concepts of bonds and the principles behind price fluctuations in an easy-to-understand way.
Why Do Bond Interest Rates and Prices Move in Opposite Directions?
The relationship between bond interest rates (yields) and bond prices—which move in opposite directions—is one of the most difficult financial concepts to grasp. Common sense suggests that a rise in bond interest rates means an increase in potential interest income, so why do bond prices fall? After all, with other investment products like stocks, real estate, and cryptocurrency, prices generally rise when investment returns increase.
How should we understand this inverse relationship between bond interest rates and prices? In this blog post, we will examine two obstacles that hinder understanding of bonds. Simply knowing that the terms “interest rate” and “price” used in economic news and financial reports when discussing bonds are not the same as the “interest rate” and “face value” listed on a bond certificate, and that—unlike other investment products—the return you can earn after a certain period is predetermined, will be a great help in understanding bonds.
Misconceptions and Truths About Bonds
Before explaining bonds, let’s first look at a paragraph excerpted from a newspaper article. How does the article describe the relationship between bond interest rates and yields? This article was published in August 2018, when the U.S. and Turkey were in the midst of a tariff war.
Amid growing concerns that Turkey’s currency crisis might spread to other countries, including Europe, the U.S. dollar continues to strengthen. As demand for U.S. Treasury bonds—considered a safe-haven asset—increased, Treasury yields fell. The preference for the dollar and U.S. Treasuries continues to rise. (…) U.S. Treasury yields showed a downward trend (bond prices rose). This was driven by increased buying of U.S. Treasuries as investor anxiety grew due to instability in Turkey’s financial markets. In the New York bond market, the yield on 2-year Treasuries fell 0.053 percentage points to 2.6% per annum. The yield on 10-year Treasuries dropped 0.076 percentage points to 2.859% per annum. The yield on 30-year Treasury bonds fell by 0.064% to 3.017%. Treasury bond prices move inversely to yields.
If you understand 100% of the content in this article without any difficulty, you don’t need to read this blog post. This is because it means you already have a precise understanding of the inverse relationship between bond yields and prices, as well as how investors’ outlook on the financial markets affects demand for bond investments. However, if you haven’t typically been very interested in the economy, this content is bound to be difficult to grasp.
You likely understand that, due to concerns that Turkey’s economic crisis could spread, there has been increased demand for the U.S. dollar and U.S. Treasury bonds, which are considered relatively safe assets. But the issue lies with the bonds. Investors have been buying up U.S. Treasury bonds, causing bond prices to rise, so why have Treasury yields fallen? While articles often state that “bond prices move inversely to interest rates,” there is no explanation as to why this is the case. First, we need to understand exactly what a bond is. Simply put, a bond is a “promissory note received for lending money to someone else.” Just as a promissory note specifies when the money will be repaid, how much interest is due, whether interest will be paid in installments or lump-sum with the principal at maturity, and whether it’s compound or simple interest, a bond contains the same information. The only difference is the terminology used for these items.
First, the most common type of bond, the “coupon bond,” refers to a bond that pays interest in installments at regular intervals. A coupon bond specifies the “par value” (the amount to be repaid at maturity), the “maturity date” (the date the money is paid), and the “coupon rate” (the interest rate paid annually to the bondholder). Depending on the bond, interest is paid in installments at regular intervals—such as every 3 months, 6 months, or 1 year—after issuance. Similar to a promissory note, it specifies how much money is being borrowed, for how long, and the interest rate and payment amounts. Since bonds are issued by governments, local governments, corporations, and public institutions to borrow large sums of money from the general public at once, they share similar characteristics with promissory notes. However, the key difference is that bonds are financial instruments that can be freely bought and sold on the securities market.
So, what benefits can investors gain by investing in bonds? There are two ways for investors in stocks to make a profit. They can earn capital gains or receive dividends for additional returns, and bond investors earn profits in a similar manner. The method of earning capital gains in stock investing is simple: buy when the stock price is low and sell when it is high, and the difference becomes profit. Bond investors can also earn capital gains by buying bonds traded in the market when prices are low and selling them when prices are high. Furthermore, since bonds have a fixed maturity date, buying them below face value and holding them until maturity results in a profit. A profit earned in this way is called a capital gain; conversely, if you buy a bond above face value, hold it until maturity, and incur a loss, this is called a capital loss. In addition to capital gains and price differences, bonds pay interest at a fixed rate, providing additional investment returns.
Now, let’s explore why bond yields and bond prices move in opposite directions, and why prices fall when yields rise. To properly understand bond yields and prices, it is necessary to accurately grasp what these terms actually refer to. The bond yields and prices mentioned in articles or reports do not refer to the interest rate or face value printed on a physical bond. Here, the term “interest rate” refers to the rate of return you can earn by purchasing a bond and holding it until maturity. Similarly, the bond price refers to the trading price of that bond in the market.
No matter what extraordinary events occur in the world, the face value and coupon rate printed on the paper itself can never change. The only things that vary depending on market conditions are the trading price circulating in the market and the expected rate of return on the investment when purchasing that bond. You must first recognize that the interest rates and bond prices discussed by financial institutions and the media correspond to the investment returns and trading prices in the market. This is the first step toward understanding the relationship between bond interest rates and prices. You might think, “Isn’t that obvious?” but far more people than you might expect misunderstand the terms “bond interest rate” and “bond price” as referring to the coupon rate and face value.
So why do bond investment returns and trading prices move in opposite directions? It is a natural phenomenon that when the investment return rises, the trading price of the investment product also rises, and conversely, when the investment return falls, the trading price also falls. Why does this rule, which applies to other investment products like stocks or real estate, not apply to bonds?
The reason is simple. Unlike other investment products, bonds are products where the profit to be received after a certain period—that is, at maturity—is already predetermined. For bonds, both the principal amount the holder receives at maturity and the interest rate on the periodic payments are fixed. Since the profit to be earned by holding the bond until maturity is predetermined, the lower the price at which you buy the bond in the market, the higher the yield; conversely, the higher the price, the lower the yield. If the amount of money you can earn after a certain period is fixed, it stands to reason that the cheaper you buy it, the greater your profit will be. Therefore, bond prices and yields move in opposite directions.
For example, let’s say there is a bond with a face value of $100 that is trading in the market for $100. If you buy this bond, you will receive $105 one year later, including $5 in interest. In this case, the annual return on investment for this bond is 5%. However, suppose the market price of the bond drops to $95 for some reason. If you buy this bond now for $95 and receive $105 one year later, the annual return on investment becomes approximately 10.52%. Since the amount you receive at maturity is fixed at $105, the lower the bond price, the higher the return on investment.
Conversely, what happens if the bond price rises? Let’s assume the price of the $100 bond mentioned earlier has risen by $5 to $105. This is the same amount you would receive upon maturity in one year. Even if you invest, you won’t make any profit. Since the annual return on investment is 0%, you’re actually losing money when you factor in inflation. As the bond price rose by $5, the investment return, which was 5%, plummeted to 0%. This is precisely why bond prices and investment returns move in opposite directions.
Why Bond Prices Change
So why do the prices of bonds traded in the market fluctuate? Like all other commodities, bond prices are determined by the principles of supply and demand. If demand exceeds supply, prices naturally rise; if demand falls short of supply, prices fall. The supply of bonds issued by large-scale issuers—such as the government, local governments, financial institutions, public agencies, and corporations—tends to remain relatively stable unless there are exceptional circumstances. Therefore, fluctuations in bond prices are often determined primarily by how many investors are seeking the bonds, that is, by demand.
While there are many factors that influence bond prices, the most significant one is the benchmark interest rate. The benchmark interest rate set by the central bank comprehensively reflects market participants’ predictions regarding the future direction of the country’s economy. Investors act based on a careful analysis of whether the benchmark rate will rise or fall, and how many times a year the central bank is expected to adjust it. The benchmark interest rate serves as a crucial benchmark for evaluating the relative returns of not only bonds but all investment products. Market interest rates, determined by private financial institutions, tend to move in the same direction as the benchmark rate.
Consider the bond mentioned earlier, with a face value and market price of $100, which pays $5 in interest after one year. If the market interest rate set by private financial institutions such as banks is 3%, investing in the bond is advantageous because its annual return is 2 percentage points higher. As an investor, it’s worth considering bond investments. However, suppose the Bank of Korea raises the benchmark interest rate, causing commercial bank rates to reach 10%. In this scenario, simply saving $100 in a bank for one year would yield $110. Consequently, no one would be willing to buy a bond that pays back only $105 after one year. Ultimately, demand for this bond would decline, causing its price to fall. To help illustrate this, I’ve assumed an extreme scenario where market interest rates suddenly jump from 3% to 10%, though such a sharp spike in rates is, of course, unlikely to occur.
Ultimately, when the benchmark interest rate rises, the relative investment returns of bonds already circulating in the market decline. Since newly issued bonds offer higher interest rates to reflect the current rate environment, existing bonds with lower interest rates become even less popular.
As demand decreases, bond prices naturally fall.
Finally, to help you better understand bonds, we will examine the various types of bonds, which are classified based on interest payment methods, issuers, and the time until maturity. Bonds are categorized into coupon bonds, discount bonds, compound interest bonds, and perpetual bonds based on their interest payment methods. Coupon bonds are bonds that pay interest in installments at fixed intervals, while discount bonds are bonds sold by the issuer to investors at a price lower than the face value printed on the bond. Since the issue price is lower than the face value, the difference between the face value and the issue price can be considered the effective interest. Compound interest bonds are bonds where interest is not paid out periodically; instead, the interest is added to the principal, and interest is calculated on that total amount. Investors receive both the principal and the interest calculated using compound interest in a single payment at maturity. Finally, perpetual bonds are bonds that do not have a fixed maturity date, which is the point at which the debt is repaid. These are bonds where only interest is paid regularly until a certain point in time. Although they are called perpetual bonds, the contract typically includes a provision allowing the issuer to repay the debt after a certain period; if these conditions are met, the principal can be repaid.
Bonds are also classified based on who issues them. As the names suggest, government bonds are issued by the national government, while municipal bonds are issued by local governments. Similarly, corporate bonds are issued by corporations, and financial bonds are issued by financial institutions such as banks. Bonds can also be classified based on their maturity period: those with a maturity of one year or less are classified as short-term bonds, those with a maturity of one to five years are classified as medium-term bonds, and those with a maturity of five years or more are classified as long-term bonds.
