How do changes in interest rates affect the value of a bond?

Changes in interest rates can have a significant impact on the value of a bond. Here’s how:

  1. Bond prices and interest rates move in opposite directions: When interest rates rise, bond prices typically fall, and when interest rates fall, bond prices typically rise. This is because bonds with fixed interest rates become less attractive to investors when interest rates rise because new bonds are issued with higher interest rates. As a result, the price of existing bonds must fall to match the higher yields offered by new bonds.
  2. Longer-term bonds are more sensitive to interest rate changes: The longer the term of a bond, the more sensitive it is to changes in interest rates. This is because longer-term bonds are exposed to interest rate risk for a longer period of time. As a result, changes in interest rates have a greater impact on the value of longer-term bonds.
  3. Coupons become more or less attractive: The coupon rate on a bond represents the fixed interest payments that the issuer pays to the bondholder. When interest rates rise, the fixed coupon payments become less attractive because they are lower than the prevailing market rates. As a result, the price of the bond must fall to match the higher yields offered by new bonds. Conversely, when interest rates fall, the fixed coupon payments become more attractive and the price of the bond may rise.
  4. Yield to maturity changes: Yield to maturity (YTM) is the total return that an investor can expect to receive on a bond if they hold it until maturity. When interest rates rise, the YTM on existing bonds increases, which means the bond’s value decreases. Conversely, when interest rates fall, the YTM on existing bonds decreases, which means the bond’s value increases.

In summary, changes in interest rates can have a significant impact on the value of a bond, with longer-term bonds being more sensitive to changes in interest rates. It’s important to understand the relationship between interest rates and bond prices when investing in bonds.