On prima facie the inverse
relationship between interest rates and bond prices would not make sense and
seem to be illogical. However, to understand the logic let us consider an
illustration of zero-coupon bond[1].
A zero coupon bond is trading at
Rs.925.00 and has a par value/maturity value with maturity in one year. Hence,
the bond’s rate of return (yield) is approximately 8.11%. The person, who bought
this bond by paying Rs.925.00, must be satisfied with 8.11% returns. But, this
satisfaction would be compared with what else is happening in the bond market
with regard to returns. If the current interest rates increases, when newly
issued bond pays 10%, then the zero coupon bond becomes unattractive. Demand
for zero coupon bonds won’t be present at all. Therefore, to attract demand for
zero coupon bonds, the price of the bond should decrease enough to match the
prevailing interest rates. In this illustration, the bond’s price should be
brought down to Rs.909.09 which offers a yield of 10.01% equivalent to the
prevailing interest rate in the bond market.
Now, let us change the situation
where the interest rates decrease to 6% in the bond market. Zero coupon bonds
looks more attractive with 8.11% returns. More people would buy the bond, which
would push the price up until the bond’s yield is matched with current interest
rate of 6%. In this illustration, the bond’s price would increase to Rs.943.39.
As the price increases, the bond holders benefit from increase in price due to
decrease in prevailing interest rates.
[1] Zero
coupon bonds are bonds with no coupon payments. Like Treasury Bills, they are
issued at a (deep) discount to the face value.
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