How interest rates exert a key influence over bond prices and their yields
Once a corporate bond is issued, it can be traded on financial markets.
Just like equities, bonds will see their prices fluctuate – although bond prices tend to be far more stable than those of equities.
A number of factors affect the price of bonds, with the outlook for the general level of interest rates being a key influence.
To provide an example, take a corporate bond that is issued by the ACME company for 10 years with an interest rate to the borrower, known as the coupon, of 4% per annum.
If your client buys the bond when it is first issued on what is known as the primary market, and holds the bond until it matures, they will get their initial investment back and receive that annual income of 4% for 10 years.
Once issued, however, bonds can also be traded on what is known as the secondary market.
Now suppose that when the bond was first issued, the official cash rate, as determined by the Reserve Bank of Australia (RBA) stood at 3%. The 4% being paid by the ACME bond would appear attractive.
How interest rates exert a key influence over bond prices and their yields
Imagine, however, that inflation subsequently takes off in Australia and the RBA hikes the cash rate to 5% to slow the economy and inflation. ACME’s 4% income rate is no longer attractive, and so the price investors are willing to pay for the bond will fall on the secondary market.
Critically, that means the income, or yield, from the bond – when investors buy it on the secondary market – will rise. Indeed, bond yields always move in the opposite direction to prices. So, if the yield goes up, the price goes down, and vice versa.
The value of corporate and other bonds is always quoted in terms of the yield, rather than the price.
So, when your clients read the financial news, they will see reports that “bond yields moved up today”, rather than “bond prices fell”.
A small move in yields can have a dramatic impact on prices
To see exactly how the yield and the bond price are connected, let’s go back to that ACME bond, which had an initial yield of 4%, paying out AUD40 of interest each year for every AUD1000 invested.
After the RBA hikes the cash rate to 5%, the AUD40 coupon remains unchanged but the price of the bond and its yield on the secondary market will change.
That is because investors – with the cash rate now at 5% – might only be willing to buy that bond on the secondary market when its yield reaches 6%. That means the price of the bond would have to fall to around AUD667 given the coupon remains at AUD40.
Similarly, the RBA might seek to stimulate economic activity by cutting interest rates to, for example, 2%. A 3% yield on the ACME bond would then seem attractive to investors, and the price of the bond would rise to AUD1330.
These examples highlight how what appears to be a relatively small movement in interest rates can significantly affect bond prices.
There are, of course, other factors that influence the price of bonds. If the financial health of the underlying company deteriorates significantly, for example, that could cause the price to fall. If the company runs into serious trouble, it might not be able to pay the coupon on its borrowings or could even default on the entire debt, rendering the bond worthless.
However, in general and on a day-to-day basis, it is the outlook for the economy and inflation – and hence interest rates – that exerts the biggest sway over bond prices.
Disclaimer: This guide contains general advice only. You need to consult with your independent financial, tax and/or legal adviser, and consider your investment objectives, financial situation, and your particular needs prior to making an investment decision. Australian Bond Exchange Pty. Ltd. and its authorised representatives does not accept any liability for any errors or omissions of information supplied in this document except for liability under statute, which cannot be excluded.