Relationship between bond prices and interest rates (video) | Khan Academy
It's when this correlation breaks down that investors start to grow concerned. That's because, when stocks and bonds move in opposite directions, it is often a It's that increased inflation that can cause bond prices to fall when inflation forces This will lead to falling interest rates, which are the result of rising bond prices. The rate at which the issuer pays you—the bond's stated interest rate or Interest rates and bond prices have an inverse relationship; so when one goes up, the. interest rates and bond prices move in opposite directions—for example, when is to provide investors with a better understanding of the relationship among.
Bonds, Interest Rates and the Impact of Inflation
Bond would trade at a discount, at a discount to par. Now, let's say the opposite happens. Let's say that interest rates go down. Let's say that we're in a situation where interest rates, interest rates go down. So how much could you sell this bond for? I'm not being precise with the math.
I really just want to give you the gist of it. So now, I would pay more than par. Or, you would say that this bond is trading at a premium, a premium to par. So at least in the gut sense, when interest rates went up, people expect more from the bond. This bond isn't giving more, so the price will go down.
Likewise, if interest rates go down, this bond is getting more than what people's expectations are, so people are willing to pay more for that bond. Now let's actually do it with an actual, let's actually do the math to figure out the actual price that someone, a rational person would be willing to pay for a bond given what happens to interest rates. And to do this, I'm going to do what's called a zero-coupon bond.
I'm going to show you zero-coupon bond. Actually, the math is much simpler on this because you don't have to do it for all of the different coupons.
The Relationship Between Bonds and Interest Rates- Wells Fargo Funds
You just have to look at the final payment. There is no coupon. So if I were to draw a payout diagram, it would just look like this.
This is one year. This is two years. Now let's say on day one, interest rates for a company like company A, this is company A's bonds, so this is starting off, so day one, day one.
The way to think about it is let's P in this I'm going to do a little bit of math now, but hopefully it won't be too bad. Let's say P is the price that someone is willing to pay for a bond. Let me just be very clear here.
If you do the math here, you get P times 1. So what is this number right here? Let's get a calculator out.
Let's get the calculator out. If we have 1, divided by 1. Now, what happens if the interest rate goes up, let's say, the very next day? And I'm not going to be very specific. I'm going to assume it's always two years out.
It's one day less, but that's not going to change the math dramatically. Let's say it's the very next second that interest rates were to go up. Let's say second one, so it doesn't affect our math in any dramatic way. Why watch the Fed? Inflation also affects interest rates.
The Fed takes an active role in trying to prevent inflation from spiraling out of control. When the Fed gets concerned that the rate of inflation is rising, it may decide to raise interest rates. To try to slow the economy by making it more expensive to borrow money. For example, when interest rates on mortgages go up, fewer people can afford to buy homes. That tends to dampen the housing market, which in turn can affect the economy. When the Fed raises its target interest rate, other interest rates and bond yields typically rise as well.
- The Relationship Between Bonds and Interest Rates
- Relationship between bond prices and interest rates
New bonds paying higher interest rates mean existing bonds with lower rates are less valuable. Prices of existing bonds fall. An overheated economy can lead to inflation, and investors begin to worry that the Fed may have to raise interest rates, which would hurt bond prices even though yields are higher.
When rates are dropping, bonds issued today will typically pay a lower interest rate than similar bonds issued when rates were higher. Those older bonds with higher yields become more valuable to investors, who are willing to pay a higher price to get that greater income stream.
As a result, prices for existing bonds with higher interest rates tend to rise. Three years later, she wants to sell the bond. That may or may not be good for bonds. Bond prices may go up. However, a slowing economy also increases the chance that some borrowers may default on their bonds.
Also, when interest rates fall, some bond issuers may redeem existing debt and issue new bonds at a lower interest rate, just as you might refinance a mortgage. If you plan to reinvest any of your bond income, it may be a challenge to generate the same amount of income without adjusting your investment strategy. Under normal conditions, short-term interest rates may feel the effects of any Fed action almost immediately, but longer-term bonds likely will see the greatest price changes.
Also, a bond mutual fund may be affected somewhat differently than an individual bond.