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Dec 16, 2015

Why do higher interest rates bring down bond prices? (Explain to me as if I were a 7-year old Series#1)


One of the things that I developed when I became a full-time mom was to simplify abstract concepts. I would read books on Finance and life philosophies, then over dinner with my sons I would talk bits and pieces of the nuggets of wisdom I get from them in easy to understand language. In retrospect, I wasn’t only doing it for them but also for myself, because unless you can explain something in simple language, you have not fully understood it yet. Hence, this series entitled Explain to me as if I were a 7-year old. smiley-163510_640

One of the not so easy to understand concepts in Finance is the Inverse Relationship of Interest Rates and Bond Prices. Why is it that when interest rates go up, bond prices go down?

Understanding Interest Rates:
Interest is the charge for borrowing money. If you are the lender, you earn it and if you are the borrower, you pay it. It is expressed as an annual percentage of the outstanding amount of the loan (the borrowed money also called Principal). It is the interest rate per annum (p.a.).

A bond is an instrument of indebtedness. The Bond Issuer is the borrower and the Bond Holder is the lender. Based on the explanation of interest above, the Bond Issuer pays the interest (also called as Coupon) while the Bond Holder earns it. The Issuer promises to pay the coupon (usually in intervals such as monthly, quarterly, semi-annually) and the principal on its maturity date (which is the end of the loan).

Very often, the bond is negotiable, meaning you can buy or sell it within the tenor or life of the loan. And this is where the dynamics of the inverse relationship of interest rates and bond prices come into play.

Bond Yield
This is the amount of return an investor will earn from the bond. For example, if you bought a bond with a par or face value of P100 and coupon rate of 10% p.a., this is how you will compute for your bond yield:
Bond Yield = Coupon / Par Value
Bond Yield = 10 / 100 = 10%

As we mentioned earlier, bonds are negotiable instruments that can be bought or sold during its term. And as in any goods and services for sale, the price of the bond is affected by supply and demand.

At this point I wish to introduce an important entity that comes into play.

Central Bank
In the Philippines we have the Bangko Sentral ng Pilipinas (BSP) and in the US they have the Federal Reserve System (Fed) created to control the money supply in the country. One of the ways to control is through interest rates. To increase money supply, the central bank lowers interest rates. To decrease money supply in the system, it does the opposite – i.e. increase interest rates.

On Wednesday there is a much-anticipated announcement from the Fed to it increases interest rates. Our BSP will have its Monetary Board meeting on Thursday and we will know how they will react to the situation.

Effect of Interest Rate on Bond Price
The simplest way to explain the inverse relationship between interest rates and bond prices is to see how zero coupon bonds, which don’t pay coupons but derive value or yield from the difference between the purchase price and the par value paid at maturity, work. (Bear in mind that the explanation below is simplistic and meant to explain this abstract concept in an easy to understand manner.)

Let’s use this example: A bond with a market value of P970 but with a par value of P1,000 (meaning, if you hold to maturity, you will receive 1,000). This gives you a bond yield computed as follows:
(1,000 – 970) / 970 = 0.309 or 3% return

What happens if interest rates go up?
Assuming that the Central Bank hikes interest rates to let’s say 5%, what happens to our bond? The investor will always look for the best yield in the market. Owning that 3%-yielding bond wouldn’t be attractive anymore. To increase demand for this particular bond, its market price would have to drop to P952, in order to give the yield of 5%:
(1,000 – 952) / 952 = .0504 or 5% return

What happens if interest rates go down?
On the other hand, let’s see what happens when interest rates go south to let’s say 1%. Owning that 3%-yielding bond becomes attractive, such that it can even increase its market price to as high as P990, and still be competitive at 1% yield:
(1,000 – 990) / 990 = .0101 or 1% return

Was that simple enough? I hope I was able to explain the inverse relationship between interest rates and bond prices to you well, something you can explain to your curious grade schooler so he won’t get intimidated when he starts taking up Finance classes in school. smiley-163510_640

Have bonds in your portfolio
I also hope that you keep bonds in your portfolio. This asset class provides the following to your portfolio: 1.) regular income; 2.) capital preservation; and 3.) diversification.

In the classic The Intelligent Investor the legendary Benjamin Graham proposed a 50-50 stock bond portfolio. The beauty of this model is that there’s an almost automatic recalibration of your portfolio. Once your stock investments get way beyond half, it signals that it’s time to sell. On the other hand, once they get way below 50%, it signals you to buy more equities.


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