Bonds have an inverted relationship with interest rates. When the cost of borrowing money increases (when interest rates increase), bond prices typically decrease, and vice versa. At first, the negative relationship may seem a little odd. However, after a closer look, it begins to make sense.

Bond Prices vs. Yield

Like most investors, they generally seek to achieve their highest return. To accomplish this, it is essential to monitor the fluctuating cost of borrowing. A simple way to comprehend why bond prices fluctuate in the opposite direction to rates of interest is to think about zero-coupon bonds. These types of bonds don't have regular interest rates and instead draw all worth from the differences between purchase cost and the par value at the time of maturity.

Zero-coupon bonds are offered at a lower rate than their par value. Yields are a function of the purchase price, par value, and the amount of time left until the maturity date. But, zero-coupon bonds guarantee the bond's yield and may appeal to investors looking for a higher yield.

Examples

If the bond is zero-coupon trading at $950 and is worth $1,000, the rate of bond at the moment is 5.26 percent. Also, a person to pay $950 for this bond should be content with the 5.26 percent return.

This happiness will naturally depend on the other developments in the bond market. If interest rates were to increase and newly issued bonds could 10-percent yield, the zero-coupon bond that yields 5.26 percent would be less appealing. Who would be interested in a 5.26 percent yield when they could obtain 10 percent?

To attract interest, the cost of the existing zero-coupon bond must fall enough to meet the return that is offered by the current interest rates. In this scenario, the bond's cost would fall from $950 (which provides a 5.26 percent yield) to $909.09 (which offers 10% of the yield).

Now that we know the basics of how the price of a bond changes with respect to changes in interest rates, It's simple to understand why bonds' prices will rise if interest rates drop. If interest rates were to drop to 3%, our zero-coupon bond with a yield of 5.26% would appear attractive. More people would be interested in purchasing the bond, pushing prices up until the bond's yield was at par with the rate of 3% currently in use. In this scenario, the price for the bond could rise to about $970.87.

In light of this rise in cost, it is clear why bondholders, who are investors selling their bonds, gain from a reduction in interest rates. These examples also demonstrate how a bond's coupon and, in turn, its market price is directly affected by interest rates. To get investors interested, newly issued bonds tend to be issued with coupon rates that align with or exceed interest rates in the country.

Zero-Coupon Bond

They are more volatile since they don't pay regular interest throughout the bonds. At the time of maturity, the bondholder who has a zero-coupon bond receives their bond amount. Therefore, they are worth more than securities increase as they near expiration.

Zero-coupon bonds also come with unique tax consequences, which investors must be aware of before deciding to invest in these bonds. While no periodic interest is paid for a zero-coupon bond, the annual cumulative return is considered income taxed in the form of interest. The bond is believed to increase in value as it nears maturity, and the increase in value is not considered capital gains taxed at the capital gains rate but instead as income.

That is, taxes have to be due on these bonds every year even though the buyer doesn't receive any money up to the date of the bond's maturity. This can be very burdensome for certain investors. But, there are methods to minimize the tax implications.

The Reason Why Bond Prices and Yields Are Inversely Related

The cost of a bond reflects the earnings it generates via regular interest payments or coupons. When interest rates drop, the value of investments tied to interest rates will decrease. However, bonds that have been issued will offer the same coupon that they have previously paid, which was dependent on a higher interest price at the time of their issue. The older bonds are an attractive option and generally will be sold at a higher price.

If interest rates increase, term deposits and newly issued bonds will offer investors more than the current bonds. So, the cost of bonds from the past will typically decrease to compensate and will be sold at a discounted price.