The impact of interest rates on bond prices

In the world of finance, bonds and interest rates are two interconnected elements. A firm grasp of the relationship between bond prices and interest rates is fundamental to understanding the dynamics of the financial market and making wise investment decisions.

This article aims to shed light on how interest rates affect bond prices.

What are bonds?

Bonds are a loan agreement between an investor and the issuer, like a company, government, or government agency. The investor essentially receives a stream of fixed interest payments periodically for a specified period, then the return of the principal amount on the maturity date.

The market value of a bond is called the bond price and is driven by investor supply and demand. The bond’s original price when it is sold for the first time it is offered is called its par value. If the bond price is above the face value, it is considered bought at premium, while if it is below face value, it is bought at discount. These are relevant to the fixed income investors since they would pay less cash if the bond is considered at a discount compared to a bond that is at premium.

When the bond matures, the annualized total return of a bond is called yield-to-maturity (YTM).

How does the inverse relationship work?

Bonds and interest rates share an inverse relationship. So, if interest rates rise, what will typically happen to bond prices? Higher interest rates affect the value of an existing bond’s yield. Bond prices go down as interest rates go up, and vice versa. 

When interest rates are hiked due to policy changes by a central bank, bond prices fall, and vice versa. In the case of the Philippines, the Bangko Sentral ng Pilipinas (BSP) is the one that controls the rates. This inverse relationship is a fundamental concept in bond investing and is often referred to as interest rate risk.

Let’s see sample scenarios:

1. Yields rise, bond prices fall: When the interest rates increase, new bonds come to the market offering higher yields. Why do bond prices fall when interest rates rise? These new bonds make the existing bonds with lower yields less attractive, reducing the market price of existing bonds.
2. Yields fall, bond prices rise: Conversely, when interest rates decrease, the yields of new bonds decrease. This makes the existing bonds with higher yields more attractive, increasing their market price.

The relationship of interest rate yield and bond prices for a 5–year bond with an annual coupon rate of 5% can be seen in the example below:

How are different bond types affected by interest rates? 

Let’s look into what affects bond prices: 

1. Fixed-interest rate bonds – Most bonds pay a fixed interest rate. If interest rates fall, this fixed rate becomes more attractive, driving up demand and the price of the bond. However, if interest rates rise, investors will no longer prefer the lower fixed interest rate paid by a bond, resulting in a decline in its price. Examples of fixed-interest rate bonds are the Metrobank Corporate Bond Fund and the Metrobank Peso Retail Treasury Bonds.
2. Zero-coupon bonds – These bonds don’t pay regular interest and instead derive all of their value from the difference between the purchase price and the par value paid at maturity. If a zero-coupon bond is trading at PHP 950 and has a par value of PHP 1,000 (paid at maturity in one year), the bond’s rate of return at the present time is 5.26%. If current interest rates were to rise, where newly issued bonds were offering a yield of 10%, then the zero-coupon bond yielding 5.26% would be much less attractive. Zero-coupon bonds are more interest rate sensitive compared to fixed rate bonds. This means that zero-coupon bonds lose more value compared to fixed interest rate bonds if interest rates were to rise.

What causes yields to increase and decrease?

While bonds are virtually zero risk investments, they are still affected by certain conditions. Let’s look into what affects bond prices:

• Inflation – Rising inflation tends to lead to the bond price being lowered as investors required higher yields to compensate the loss of purchasing power of the investor. Bond prices are quite sensitive to changes in inflation and inflation forecasts. Therefore, investors need to keep a close eye on the economic environment, which is affected by any form of rate cuts or rate hikes, to make informed decisions about their bond investments
• Interest rate policy – Changes in Interest rate policies set by a central bank would significantly affect the yields of the bond as it also serves as a benchmark for the coupon rate setting of new bonds being issued. The new issuances of bond with higher yields would make the existing similar bonds with lower yields less attractive, reducing the market price of existing bonds to match the yield of the new bonds.
• Issuer’s financial health – Issuers with stronger financial conditions, such as creditworthy or well-renowned banks, tend to have lower yields compared to less financially stable issuers which offer higher yields to compensate the investor taking additional credit risk.
• Credit ratings – Any possible changes to the credit ratings of a company might cause a rally in its bonds prices as investors would require lower yields due to its decreased credit risk.

Be a smart investor with Metrobank

Bonds offer a secure investment for investors, but they are not immune to shifts in the market. As an investor, it’s important to understand what happens to bond prices if interest rates rise or fall so you can make the best decisions to meet your financial goals. 

Get updated insights about investment outlook with Metrobank. Get in touch with us about any investment concerns.

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ALEXANDER VILLAFANIA is a writer for Metrobank’s Wealth Insights. For almost 20 years, he authored stories on science, technology, and education as a journalist for several local news organizations. He has since transitioned to writing more about financial literacy, believing that helping people develop a healthy relationship with money is key to enabling positive socio-economic and environmental change.

JOSHUA TATLONGHARI is a Financial Markets Analyst at Metrobank’s Institutional Investor Coverage Division. He holds an undergraduate degree in finance from the University of Santo Tomas and is currently taking a Master’s degree in Applied Economics at De La Salle University-Manila. He spends his free time working out and watching documentary videos relating to finance and the economy.

HANS NIGEL P. MARCELO is an intern at the Institutional Investors Coverage Division of Metrobank, taking on roles in relationship management and research and business analytics. He is currently taking his undergraduate studies at the De La Salle University – Manila.