The relationship between bond prices and interest rates

Bonds offer investors an excellent means of managing overall portfolio risk. Bonds are a conservative investment because typically they provide a fixed, predictable income stream. However, bond prices themselves can fluctuate. Bond prices are mainly determined by changes in interest rates.

An inverse relationship exists between bond prices and interest rates. This relationship is usually immediate and predictable. When you buy a bond, you are essentially taking a view that interest rates are likely to remain the same or decrease.

If interest rates rise, bond prices will fall. This is because they must be sold at a discount in order for the investor buying the bond to earn the current market rate of interest. On the other hand, if interest rates decline, bond prices will rise since the coupon rate will be higher than the current market interest rate.

Bond volatility

Bond volatility can be a difficult concept to grasp. However, as an investor in bonds, you should at least be aware of the following two points in relation to interest rate changes:

• Bond prices are more sensitive to a reduction in interest rates than to an increase in interest rates
• Low coupon bonds are more sensitive to interest rate changes than high coupon bonds

The relationship between interest rates and maturity

Interest rate changes do not affect all bonds equally. The longer the term to maturity of a bond, the greater the risk that the market price of the bond will differ from the maturity value.

In return for taking on the additional risk associated with longer-term bonds, investors expect to receive compensation in the form of increased yield. As a result, there is a direct link between maturity and yield, a link explained by the yield curve.

A yield curve is a graph in which interest rates are plotted against term to maturity for bonds of the same credit quality. Analysts, traders and investors study the shape of the yield curve carefully because it contains built-in expectations about future trends in interest rates.