Bond Prices and Interest Rates

This topic normally comes up in A2 as a multiple-choice question or as part of an essay on the money markets. It is something that my A2 students have found difficult to understand. Bond prices and interest rates are inversely related – Interest Rates ↑ = Bond Prices ↓ and Interest Rates ↓ = Bond Prices ↑

Say you buy a 10 year Treasury Bond is issued for $1,000 for five years with a coupon (interest rate) of 5% per annum, meaning it pays $50 per year in interest. You decide to sell your Bond on the secondary market to get your money back. However, the RBNZ has raised interest rates and 10 year Treasury Bonds are being issued with a 7% coupon rate (interest rate). Therefore these new Bonds are sold at $1,000 and pay $70 per year in interest. If you now want to sell your Bond you will have lower its price to around $714. Your Bond still pays $50 per year in interest, as stipulated in the Bond’s contract. However, the new owner buys it for $714 and receives $50 per year in interest, which calculates to a 7% interest rate (50÷0.07 = 714). The actual coupon payment has not changed ($50) but the ratio of that coupon payment to the price has changed.

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