How Raising Interest Rates effect Bonds/Loan prices?
It is important to understand why rising interest rates are having such a devasting impact on banks and bond holders. Hopefully this will help explain why regional banks are having some issues in the current interest rate market.
If you own a bond with the following characteristics:
Face value (principal): $1,000
Coupon rate: 5%
Maturity: 10 years
Your bond pays a fixed annual coupon payment of $50 (5% of $1,000) for 10 years, and at the end of the 10 years, you will receive the principal amount of $1,000.
Now, let’s assume that when you purchased the bond, the prevailing interest rate in the market was 4%. At that time, the bond’s coupon rate of 5% was attractive compared to the market rate, so you were willing to pay a premium for the bond, let’s say $1,100.
In this scenario, the yield on the bond would be lower than the prevailing interest rate since you paid a premium. The yield is calculated by dividing the annual coupon payment ($50) by the bond’s price ($1,100), which results in a yield of approximately 4.55%.
Now, let’s say that interest rates rise in the market due to various factors such as economic conditions or monetary policy changes. The new prevailing interest rate becomes 6%.
As interest rates increase, new bonds are issued with coupon rates of 6% to attract investors. Since your bond only offers a 5% coupon rate, it becomes less appealing compared to the newly issued bonds.
To remain competitive, your bond must adjust its price in the secondary market to offer a higher yield that reflects the new interest rate environment. This means that the bond’s price must decrease.
To calculate the new price of the bond, we need to determine the yield that aligns with the new interest rate of 6%. Let’s assume that the bond’s price decreases to $950 to achieve a yield of approximately 6.32%. The new price reflects the higher yield required by investors to hold a bond with a lower coupon rate compared to newly issued bonds.
So, in this example, when interest rates rise from 4% to 6%, the price of your bond decreases from $1,100 to $950. This illustrates the inverse relationship between interest rates and bond prices.
It’s important to note that this example simplifies the calculations and assumes a static interest rate change. Bond prices can be influenced by various market factors, and interest rate changes may occur gradually or abruptly. Building a laddered bond approach can help protect from fluctuating rates.