Relationship of Bonds and Interest Rates
Bond prices and interest rates vary in an inverse fashion, such that high interest rates lead to low bond prices, while low interest rates lead to high bond prices. If the current rates are in the region of 9% yet the coupon rate of a bond lies at 6%, an investor will not be willing to pay the full face amount for the bond in question. The coupon rate and the prevailing interest rates are extremely close to each other and this aims to make the bonds attractive. However, the prevailing interest rates change over time to be above of the coupon rate. The investors purchase bonds that have a high propensity of high income and favorable interest rates.
An old bond price with a coupon rate higher than the prevailing interest attracts more investors than bonds set at such a time based on these low, prevailing interest rates with low coupon rates. Therefore, the old bonds’ pricings will be much higher than the new bonds’ pricings that have low coupon rates due to low interest rates. The higher coupon rate of the old bonds makes them to have a competitive edge over the new bonds.
If interest rates increase, old bonds, whose coupon rates approximate the previous, low interest rates will have low pricing, as the new bonds of the same rating and maturity will be more marketable; thus, go for more than the old bonds.
Increasing interest rates make long-term bonds become a loss due to the increasing low pricing that they will suffer gradually. However, short-term bonds suit this case, as they offer less risk of long negative fluctuation, as the bond matures early to avoid increased losses.
Reducing interest rates suit long-term bonds, as the investors gain enormous capital gains from such a situation. Short-term bonds do not utilize this opportunity of increasing bond price due to reducing interest rates maximally.
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