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Student Question of the Week: Investments

Student Question from: Ben H.
Course:  Investments – Bonds and Interest Rate Relationship

Student Question:

From mid contraction to trough in the business cycle cycle, why do bonds do well? I don’t understand the relationship between bonds value going up if interest rates are going down? Please help. Thanks


Instructor Response:

Hi Ben!

Your question brought back a memory of when I first studied this concept many years ago. The instructor did a John Travolta disco dance pose straight out of Saturday Night Fever, where he pointed up in front of him with one arm while pointing down behind him with the other; then he switched directions, lowering one arm while raising the other. He continued switching positions back and forth, one time saying “when interest rates go up, bond prices go down” and the next time saying “when interest rates go down, bond prices go up.” We all laughed, but I never forgot that inverse relationship between interest rates and bond prices.

Let me see if I can illustrate why. Let’s assume current interest rates are 5% and you purchase a new bond for $1,000 (its par or face value) that pays 5% interest per year. You now own a bond that pays you $50 per year. Now, let’s suppose interest rates go UP to 10% and people can purchase new $1,000 par value bonds that will pay a current rate of 10%, or $100 per year. Well, here you are stuck with a bond that is only paying $50 per year. If you go to sell it, can you sell it for $1,000? Absolutely not.  People can go elsewhere and pay $1,000 for a new bond that will pay them $100 per year. Therefore, you must LOWER the price of your bond to sell it in the market. Your bond is thus worth LESS, because interest rates ROSE.

Now, let’s reverse it and say current interest rates fall to 2%. Well here you are owning a bond that pays $50 when people can only get $20 on a new bond paying the current market rate. So now, because interest rates went LOWER, you can ask for a HIGHER price for your bond.

I hope that helps to clarify.