Question

Explain the concept of how bond values change through time. Explain the implication(s) this pattern has for interesr rate risk. Show the interest rate implication(s) at the end of your answer.

Answer 1

Bond is a type of Debt in which the company who issues the bond has the obligation to pay Interest in a pre determined time and then will have to reedem the facevalue at maturity.

So Bond is a debt and has interest rate attach with it, now this interest rate are fixed at the time of issue of bond, But the interest rate of market changes from time to time. This is the reason that bond values changes throughout time.

Let say company X issue bond face value at $100 paying coupon interest 5% p.a. in year 2018. Now let say market interest rate is also 5% in year 2018, Hence the bond interest is as per market interest bond is trading at par, people will buy the bond at $100 par value only.

Now suppose in year 2018, Market interest rate is 7%, so people who has will not invest in $100 in bond of Company X as because bond is paying only 5% and market is giving 7%, so people want to invest in market to get higher returns of 7%. so, at that time the bond price will be discounted and Bond will be issued at lower then $100 and hence the price changes accordingly. On the other hand if market is paying lower interest say only 3% at that time all people will want to invest in Company X bond tpo get higher return and so the demand will increase for the bond and bond will trade at premeium i.e. higher then $100.

So, we have seen there is an Inverse relation between Bond price and market interest rate. Bond price will change opposite direction with the change in the interest rate. i.e. if market interest fall bond price will rise and if market interest rate increase bond price will fall.