Interest rates & bonds prices

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CA Nataraju Dyavanapelly (Querist)
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25 November 2013 When the interest rates falls, bond prices rises. when the interest rates rises, bonds prices falls. in other words bonds prices are inversely related to interest rates. why?

Nikhil Kaushik

Nikhil Kaushik (Expert)
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26 November 2013 Dear Nataraju,

the link is simple, every investor looks for a higher yield.

This desire for higher yield results in this negative relationship between interest rates and bond pricing.

Take an example: (for simplification)

Today, you issue Rs 1000 bond at 5% interest rate. Thus, the annual yield shall be 5%.

Now a month later, I issue a Rs 1000 bond at 6%.

Now in the same bond market for a same issue price you have two bonds with different coupon rate. So it is but natural that the investors should shift from 5% coupon to 6% coupon.

This shift would result in the fall of Rs 1000 5% bond price. Now this fall will continue till the yield reaches 6%. So Rs 1000 5% bond shall fall to Rs 833.

However since the interest is still paid on Rs 1000, the Rs 50 return will give you 6% yield.

This inverse movement of bond price - from Rs 1000 to Rs 833 is to bring the yield on par with the new issues.

For equivalence: 1000*6% = 833*5%

One of the best effect of inverse relationship is the Harshad Mehta Scam. It is said that had not Indian govt issued higher coupon bonds during that period, harshad Mehta may very well have gone down as the biggest Bull instead of dying an anonymous death.

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