Why do bond prices fall as bond interest rates and yields rise? This explains the basic concept of bonds and the principle behind price fluctuations in an easy-to-understand manner.
Bond Interest Rates and Prices: Why Do They Move in Opposite Directions?
The relationship between bond interest rates (yields) and bond prices, which move in opposite directions, is one of the more difficult financial concepts to grasp. Common sense suggests that a rise in bond yields means increased interest income, so why do bond prices fall? After all, when investment returns rise for other assets like stocks, real estate, or cryptocurrency, their prices typically rise too.
How should we understand this inverse relationship between bond yields and prices? This blog post examines two obstacles that hinder understanding bonds. Understanding that the terms ‘interest rate’ and ‘price’ used in economic news and financial reports when discussing bonds do not refer to the ‘interest rate’ and ‘face value’ written on the bond certificate itself, and that unlike other investment products, bonds have a predetermined return that can be collected after a set period, will greatly aid in understanding bonds.
Misconceptions and Truths About Bonds
Before explaining bonds, let’s examine a paragraph excerpted from a newspaper article. How does the article describe the relationship between bond rates and yields? This article appeared in August 2018, when the US and Turkey were in the midst of a tariff war.
Amid heightened concerns that Turkey’s currency crisis might spread to other countries like Europe, the US dollar continues to strengthen. As demand for safe-haven US Treasuries increases, Treasury yields have fallen. The preference for dollars and US Treasuries keeps rising. (…) U.S. Treasury yields showed a downward trend (bond prices rose). This occurred as investor anxiety grew due to instability in Turkey’s financial markets, leading to increased buying of U.S. Treasuries. In the New York bond market, the yield on the 2-year Treasury note fell 0.053% to 2.6% per annum. The yield on the 10-year Treasury note dropped 0.076% to 2.859% per annum. The 30-year Treasury yield fell 0.064% to 3.017%. Treasury 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 implies you precisely grasp the inverse relationship between bond yields and prices, and how investor outlooks on financial markets influence bond investment demand. However, if you don’t usually follow economic news closely, this content is bound to be difficult to understand.
You might grasp that concerns over Turkey’s economic crisis potentially spreading have boosted preference for the U.S. dollar and Treasury bonds, seen as relatively safe assets. But the problem lies with bonds. Why did Treasury bond yields fall when investors buying U.S. Treasuries caused bond prices to rise? While the article mentions that “Treasury bond prices move inversely to yields,” it doesn’t explain why. First, we need to understand exactly what bonds are. Simply put, a bond is a ‘promissory note received for lending money to someone else’. Just as a promissory note specifies when the money must be repaid, how much interest is owed, whether interest is paid in installments or combined with the principal at maturity, and whether it’s compound or simple interest, bonds contain the same information. The terminology used for these items is slightly different, however.
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). Interest is paid in installments at fixed intervals after issuance, such as every 3 months, 6 months, or 1 year. Similar to a promissory note, it specifies the amount borrowed, the repayment period, the interest rate, and the payment schedule. Bonds themselves are issued by governments, local authorities, corporations, public institutions, etc., to borrow large sums of money from the general public at once, so they share similar characteristics with promissory notes. The key difference is that bonds are financial products freely tradable in the securities market.
So, what benefits can an investor gain by investing in bonds? Investors in stocks typically profit in two ways: They either gain capital gains from price fluctuations or receive dividends for additional income. Bond investors also profit in similar ways. In stock investing, capital gains are straightforward: buy low, sell high, and the difference becomes profit. Similarly, bond investors can earn capital gains by buying bonds cheaply on the market and selling them at a higher price. Furthermore, since bonds have a fixed maturity date, buying them below par value and holding them until maturity yields a profit. This type of gain is called a capital gain. Conversely, if you buy a bond above par value and hold it until maturity, incurring a loss, that is called a capital loss. Beyond capital gains and losses, bonds also provide additional investment returns by paying interest at a predetermined rate.
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’s essential to grasp exactly what these terms refer to. The yield and price of a bond mentioned in articles or reports do not refer to the interest rate printed on the physical bond certificate or its face value. The term “interest rate” here refers to the yield one can earn by purchasing the bond and holding it until maturity. Similarly, the bond price signifies the market trading price of that bond.
No matter what extraordinary events occur in the world, the face value and coupon rate printed on the physical bond itself can never change. What fluctuates according to market conditions are only the trading price circulating in the market and the expected investment yield when purchasing that bond. First, you must recognize that the interest rates and bond prices discussed by financial institutions and the media correspond to the investment yield and trading price in the market. This is the first step to understanding the relationship between bond yield and price. You might think, ‘Isn’t that obvious?’ Yet, far more people than you’d expect misunderstand the terms ‘bond yield’ and ‘bond price’ as referring to the coupon rate and face value.
So why do bond investment yield and trading price move in opposite directions? It seems natural that when the investment yield rises, the trading price of that investment product should also rise, and conversely, when the investment yield falls, the trading price should also fall. Why doesn’t this obvious principle apply to bonds, as it does to other investment products like stocks or real estate?
The reason is simple. Unlike other investment products, bonds are products where the profit that can be collected after a certain period, i.e., at maturity, is already predetermined. Bonds have a fixed amount the owner receives at maturity and a fixed interest rate paid periodically. Since the profit obtainable by holding until maturity is predetermined, buying bonds cheaply in the market increases the investment yield, while buying them expensively lowers it. If the money you can earn later is fixed, it stands to reason that buying cheaper yields greater profit. Therefore, bond prices and yields move inversely.
For example, consider a bond with a face value of $100 that trades at $100 in the market. Buying this bond means you will receive $105 after one year, including $5 in interest. This bond’s annual investment yield is therefore 5%. However, for some reason, the market price of this bond drops to $95. If you buy this bond now at $95 and receive $105 after one year, the annual investment yield becomes approximately 10.52%. Since the amount receivable at maturity is fixed at $105, the lower the bond price, the higher the investment yield.
Conversely, what happens if the bond price rises? Suppose the price of the initially mentioned $100 bond increases by $5 to $105. This amount is identical to the money you would receive upon maturity repayment one year later. Even if you invest, you gain no profit. With an annual investment return rate of 0%, factoring in inflation means you actually incur a loss. As the bond price rises by $5, the investment return rate, which was 5%, plummets to 0%. This is precisely why bond prices and investment returns move in opposite directions.
Why Bond Prices Change
So why do bond prices fluctuate in the market? Like all other commodities, bond prices are determined by the principles of supply and demand. When demand exceeds supply, prices naturally rise; when demand falls short of supply, prices drop. The supply volume of bonds issued by large issuers like governments, local authorities, financial institutions, public agencies, and corporations doesn’t fluctuate significantly unless there are special circumstances. Therefore, bond price movements are often primarily determined by how many investors seek the bonds—that is, by demand.
While many factors 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 about the future direction of the country’s economy. Investors move based on 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 rate serves as a crucial benchmark for evaluating the relative returns of not only bonds but all investment products. Market interest rates set by private financial institutions also move in tandem with the benchmark rate.
Recall the bond example mentioned earlier: one with a face value and market price of $100, paying $5 in interest after one year. If the market interest rate set by banks and other private financial institutions is 3%, investing in the bond is profitable because its annual investment return is 2 percentage points higher. Investors should consider looking into bond investments. However, suppose the Bank of Korea raises the base rate, causing commercial bank rates to jump to 10%. In this scenario, simply saving $100 in a bank for one year would earn $110. Consequently, no one would buy a bond that only pays back $105 after one year. Ultimately, demand for this bond would decline, causing its price to fall. To aid understanding, we’ve assumed an extreme scenario where market rates suddenly jump from 3% to 10%. Of course, such a sharp spike in rates is unlikely to occur.
Ultimately, when the base rate rises, the relative investment returns of bonds already circulating in the market decrease. Newly issued bonds will offer higher interest rates reflecting the current rate level, making existing bonds with lower rates even less popular. As demand decreases, bond prices naturally fall.
Finally, to aid understanding of bonds, we will also examine the various types distinguished by interest payment methods, the issuer, and the time until maturity and redemption. Bonds are categorized based on interest payment methods into coupon bonds, discount bonds, compound interest bonds, and perpetual bonds. Coupon bonds are bonds that pay interest in installments at fixed intervals. Discount bonds are bonds sold by the issuer to investors at an issue price lower than the bond’s stated face value. The difference between the face value and the issue price is effectively the interest. Compound interest bonds do not pay interest periodically but instead add the interest to the principal, calculating interest on the new total amount. Investors receive both the principal and the interest calculated on the compound total at maturity. Finally, perpetual bonds have no fixed maturity date, meaning there is no set time for repayment. They pay only interest regularly until a certain date. Although called perpetual bonds, the contract includes a clause allowing the issuer to repay the money after a certain period. If this condition is met, the principal can be repaid.
Bonds are also classified based on where they are issued. As their names suggest, government bonds are issued by the state, while municipal bonds are issued by local governments. Similarly, corporate bonds are issued by corporations, while financial bonds are issued by financial institutions like banks. Bonds can also be categorized by their maturity period: those maturing in one year or less are short-term bonds, those maturing between one and five years are medium-term bonds, and those maturing in five years or more are long-term bonds.
