Kavan Choksi / カヴァン・ チョクシ Talks About the Relationship Between Bond Prices and Interest Rates
The Federal Reserve plays a vital role in shaping the economy of the United States. Its primary goal is to maintain economic stability by making sure that the economy does not fall into recession or overheats. As Kavan Choksi / カヴァン・ チョクシ says, one of the primary tools employed by the Feds to achieve this goal is interest rate policy. Government policies and interest rate decisions can have a considerable impact on bond markets, and affect everything, right from yields to investor demand. Hence, having a good understanding of the relationship between bond prices and interest rates is important for investors. These insights would allow them to make informed decisions about when to buy, sell, or hold bonds.
Kavan Choksi / カヴァン・ チョクシ Briefly Discusses the Relationship Between Bond Prices and Interest Rates
As the economy experiences robust growth, there would be a risk of inflation and asset bubbles forming. The Fed raises interest rates in order to counter these inflationary pressures. Higher interest rates make borrowing more costly, which can reduce inflationary pressures and slow down economic activity. However, when the economy is sluggish, the Fed will lower interest rates. The bond market, which is a vast global marketplace, tends to be highly sensitive to interest rate changes. Bonds imply to loans that investors make to corporations and governments. Investors typically receive periodic interest payments and the principal back at maturity.
The relationship between interest rates and bond prices is inverse. As interest rates go up, the value of existing bonds is likely to fall. This happens because new bonds would be issued at higher interest rates and hence would be more attractive to investors, thereby making older bonds having lower interest rates less desirable. Hence, investors would be willing to pay less for older bonds, causing their prices to decline.
On the other hand, when interest rates fall, the value of existing bonds rises. The new bonds issued at lower interest rates are less attractive to investors, which automatically makes older bonds with higher interest rates more desirable. Therefore, in such a situation, investors are likely to pay more for older bonds, which causes their prices to increase.
As Kavan Choksi / カヴァン・ チョクシ says, while understanding the relationship between interest rates and bond prices might be confusing at the beginning, doing so is important to make informed investment decisions. In case one has plans to hold a bond to maturity, interest rate risk might not be a major concern. The investor would be primarily focused on receiving the bond’s face value, or par value, when it matures, in such a situation.
Whether a bond is issued by a government or a corporation, the overall mechanics of bond pricing shall be the same. Bonds are issued at a specific rate of interest that the issuer will pay to investors. This is known as the coupon. Once it is issued, the coupon never changes. However, the prevailing interest rates may change. When this does happen, the coupon rate of an existing bond might become more or less attractive by comparison, which affects its price.
