Question

If there are 2 bonds, how do i know which bond is more likely to be affected by a change in interest rates, in regards to price, market yield, coupon rate, duration and maturity.

Answer 1

Relation between interest and bond price- There is an inverse relationship between bond price and interest rate. If interest rates rise, bond prices fall and vice-versa. This is beacuse when market interest rises say to 12%, the bond paying fixed coupon amount of $10 on the par value of $100 (which is equal to 10% return) will become less attractive to investors and hence its price will fall to compensate the lower return. Similarly when interest rates fall say to 8%, the same bond will become more attractive and hence its price will rise. This also explains the relationship between interest rate and market yield meaning when interest rates rise, the bond price reduces but the coupon amount remains same thereby increasing the yield on the bond. taking the same example, when interest rate rose, the bond price reduced from $100 to $95. but the coupon amount remained same i.e., $10. hus the yield of the bond became= 10/95= 10.5% .

Relation between interest rate and coupon rate- Interest rates and decided and controlled by government based on market conditions. Coupon rates are paid by bond issuers to bondholders. When the bonds are issued, the coupon rates are usually higher or at par with the prevalent interest rates else, the bonds have to priced very less.

Relation between interest rate and duration- Duration is the total time (years) for the bondholder to recieve back the principal amount. Bonds with higher duration will be subject to higher interest rate risk

Relation between interest rate and maturity- Bonds with higher maturity have longer duration and hence are more subject to interest rate risk.