Corporations and governments borrow money by selling bonds to investors like you. In turn, you want a good interest rate on the money you lend. The effective interest rate you get depends on several factors. Understanding the relationship between a bond prices and interest rates helps you analyze whether a bond is a good investment.
Coupon Rate and Yield
A bond’s stated interest rate is called the coupon rate. Coupon rate is calculated by dividing the coupon -- the fixed annual interest sum a bond pays -- by the par value of the bond. Par value, in turn, is the amount the bond issuer must give the bond owner to pay off the debt when the bond matures. Bonds vary in price as they are traded, and this makes the effective interest rate, called the yield, change as well. You figure the yield by dividing the coupon by the price of the bond. For example, a $1,000 par value bond with a 6 percent rate might be selling for $800. When you divide the coupon ($60) by the price, you get a yield of 7.5 percent. This example illustrates a basic rule about the relationship between bonds and interest rate: when the price goes down, the yield goes up, and vice versa.
Market Interest Rates
Suppose prevailing market interest rates that bonds pay go up so that existing bonds pay lower yields than newly issued ones. Investor demand for existing bonds falls, causing the price to drop. As the price declines, the yield goes up until it is comparable to the new market rates. The opposite occurs when market rates go down. An existing bond then has a better yield, so demand for it rises. This pushes its yield down.
Bond issuers have credit ratings just like you do. These ratings are important because they allow you to estimate the risk that a bond issuer will default on the debt. For example, bonds with the least credit risk are rated “AAA” by the three major ratings services: Fitch’s Ratings, Standard & Poor’s and Moody’s. If a company runs into trouble, its bonds might be downgraded to “AA.” That’s still pretty good, but it does mean the bond is a riskier investment. Typically, investor demand falls and the price goes down. The price will decline until the yield goes up enough to attract investors willing to take more risk in return for a higher interest rate.
Maturity and Interest Rates
Bonds can be classified according to their lifespan, ranging from short-term to long-term. The price and yield on a short-term bond with a maturity of a year or less usually stays close to the par value and coupon rate. This happens because market rates don’t often change enough in a short time to have a big impact. Also, investors can make a good estimate of the near-term credit risk of the bond issuer. The longer the time until a bond matures, the more likely it is that market interest rates or a bond’s rating will change enough to have a major impact on a bond’s price and therefore its yield.