There is an inverse relationship between market interest rates and the prices of corporate bonds. When interest rates move up, bond prices go down. When interest rates fall, you are likely to see bond prices moving upward. For this reason, investors pay close attention to economic factors that influence changes in market interest rates.
Price and Yield
Knowing how a bond’s price relates to its effective interest rate is key in understanding how economic interest rates affect corporate bond prices. Bonds pay a fixed amount of yearly interest, called the coupon. You calculate the interest rate, or coupon rate, by dividing the bond’s par into the coupon. Thus, a $1,000 par value corporate bond with a $60 coupon pays a coupon rate of 6 percent. Corporate bond prices are usually different from the par value and this alters the effective interest rate, or yield. If you pay $900 for a $1,000 par value bond with a 6 percent coupon rate, dividing the price into the coupon gives a yield of 6.67 percent. The same bond, purchased for $1,100, has a yield of 5.45 percent. This pattern always holds: when bond prices go down, yields go up and vice versa.
Market Rates and Bond Prices
Suppose interest rates in the economy go up. Newly issued bonds paying higher rates are a better deal for investors than existing bonds. Demand shifts away from existing to newly issued bonds, so the prices of existing bonds falls. Conversely, if interest rates decline, existing bonds have higher yields. Investor demand for existing bonds increases, driving prices up.
Supply of Money
In financial markets, borrowers buy and lenders sell the use of money. Interest is the price of borrowed money. When the economy is growing, demand for money is high and interest rates tend to climb. Higher rates push corporate bond prices down. Interest rates also rise when the Federal Reserve “tightens,” or reduces, the money supply. Demand for the reduced supply of money pushes interest rates up and bond prices go down. The opposite occurs if the economy slows down or the Federal Reserve adds to the money supply. Supply increases relative to demand for funds, pushing interest rates down and corporate bond prices up.
Increases in inflation tend to lead to higher interest rates and lower corporate bond prices. Investors worry that high inflation will erode the purchasing power of the money they invest in corporate bonds. That is, when bonds reach maturity and are paid off at par value, the money an investor gets back won’t be worth as much as the dollars used to buy bonds. To attract investors, corporate bond issuers must offer higher interest rates on corporate bonds. The higher interest rates offset the risk that inflation will erode the value of invested money; the rise in interest rates results in lower corporate bond prices.