What is the relationship between bond prices and interest rates

We’ll start with a few facts about investing, and the relationship between interest rates and bond prices:

– Rising share prices and property values make for happy investors.

– An increase in interest rates results in higher term deposit rates and again, investors are pleased.

– An increase in bond yields however, does not always please investors. In fact, if often leaves them confused and uncertain about the impact on their bond investments.

Read on to learn more about the relationship between interest rates and bond prices.

There are two key components to be aware of when you buy a bond – its price and its yield.

When you buy a bond, you are effectively making a loan to that corporation. In return for borrowing your money, the bond is repaid in a specified time period. And, for the duration of the loan, you are rewarded with regular coupon (or interest) payments. A bond’s yield is the total value of these payments over the lifetime of the bond, incorporating the $100 face value received at maturity. It is the total return the investor can expect to receive, subject to no default.

The coupon payment amounts are set at the time the bond is issued, according to prevailing interest rates. The yield is generally higher than the cash rate, to make the bond a more attractive investment than a term deposit¹.

If you buy a bond when it is issued and hold it through to maturity, the investment will not be affected by changes to interest rates. As illustrated in figure one, coupon payments remain the same for the duration of the investment, and at maturity, the face value is repaid.

Key point #1 – a bond bought at issue and held to maturity is not affected by changes to interest rates

Figure one: A bond bought at issue and held to maturity

Bond prices and interest rates

Key point #2 – a bond’s price moves in the opposite direction of its yield

A buy and hold strategy is straightforward. However, if you wish to buy (or sell) a bond on the secondary market (i.e. after it has been issued), the relationship between the bond’s price and its yield becomes important.

This relationship is sometimes depicted as a see-saw – as one rises, the other falls. As illustrated in figure two, the two factors have an inverse relationship; in other words, a bond’s price moves in the opposite direction of its yield.

Figure two: the effect of interest rates on bond yields and bond prices

Why bond prices and yield are inversely related

The price of a bond reflects the value of the income it provides via regular coupon or interest payments.

The relationship between interest rates and bond prices:

• If interest rates rise, term deposits and newly issued bonds will pay investors higher rates than existing bonds. Therefore, the price of older bonds will generally fall to compensate and sell at a discount. This is currently that case for many of the XTBs available on exchange.
• If interest rates fall, the value of investments related to interest rates fall. But bonds that have already been issued will continue to pay the same coupon amount as they did previously – a rate which was based on a higher interest rate at the time they were issued. These older bonds then become a more attractive proposition and will generally sell at a premium.

Key point #3 – when a bond sells at a discount, its price is lower than its issue price. When it sells at a premium, its price is higher than its issue price.

How the bond price and yield relationship affects XTBs

As well as an original face value and coupon rate, each XTB has a current price, a current yield determined by its coupon rate and price, and a yield to maturity.

We provide a table of available XTBs, which is updated daily using the previous market close data. This interactive table provides details of the available XTBs, and includes fixed and floating rate bonds across a range of sectors.

Figure three: Key measures of a corporate bond

Figure three details the data you should review when considering an investment in a Qantas QF4 XTB. This example shows an XTB where interest rates have increased (the current yield is higher than the coupon rate). Therefore, this XTB’s current price is lower than its face value:

• The coupon rate of 2.95% would be paid to those investors who bought at issue (at $100) and held to maturity
• An investor who bought at issue and sold this XTB today would lose from the price depreciation
• An investor buying the XTB today would pay a lower price than its face value
• An investor buying the XTB today, would benefit from price appreciation as the bond price is pulled to the $100 face value at maturity.

View the range of available XTBs

Key point #4 – the Yield to Maturity is the ‘total return’ you should receive if you buy the bond today and hold it to maturity

If you are considering XTBs for your portfolio, use the tools available to help you determine the most appropriate investment(s), given your income needs and likely investment time frame.

¹Term Deposits may enjoy the benefit of protection under the Financial Claims Scheme.

This article was first published in August 2017, updated in February 2021 and October 2022

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