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Bonds are considered less risky forms of investments than stocks, as the former does not have the same volatility as the latter has. It represents a promise to pay when the indebted entity, the bond issuer, borrows money from a buyer of the bond, the bondholder. Bonds are used by the government and private companies to finance desired projects. The interest rate of a bond is fixed when it is first issued. The payment comprises of two parts – the fixed bond interest rate or coupon and the final amount to be paid upon maturity. The fixed coupon rate may be annually or every 6 months depending on the type of bond. Bonds can be adversely affected by prevailing economic conditions such as rising interest rates.
An entity issues a bond with a face value of $1,000 at an interest rate of 5%. This will result to a payment of $50 every year to the bondholder until maturity. The 5% is determined from the prevailing market conditions. The investor can then be assured of an annual return of 5% from the bond.
Why changes in interest rates matter to bondholders?
Bond prices get affected by interest rates. If you plan to hold on to the bond, the value will not change just because interest rates went up or down; you will still get the amount as promised. If you have set a goal to achieve that amount within a certain period, then there is no problem. But if you buy bonds for investment purposes as you would stocks, then this change in the market conditions matter. Higher interest rates lower the value of a bond while lower interest rates tend to increase the valuation of a bond.
What happens when interest rates change?
If, for some reasons, general interest rates rise, say to 8%, the value of the bond already issued with an interest rate of 5% in the open market will go down. No investor would buy a bond on the secondary market with an interest rate of 5% when new bond issues of the same quality are paying 8%. The bond issuer would then need to compete with new bond issues by selling the bond in the secondary market at a discount to its face value. Instead of $1000, the bond price will have to go down to $625 (that is $50 divided by 8%) to offer a potential buyer with the same 8% return.
When interest rates go down to 3% for example, the bond will increase in value. Any investor will grab the bond with a yield of 5% you are issuing on the secondary market because new issues are only yielding 3%. The bond issuer will take advantage of this by selling the bond at a premium on the secondary market. To offer a potential buyer with an interest rate of 3%, the bond price should be raised to $1,666.67 (that is – $50 dividend by 3%).
Therefore, bond prices go up when interest rates are low and go down when interest rates are high. Suffice it to say, bonds are attractive additions to your investment portfolio under low interest rates regime.