Question

Explain the effect of interest rates on bond pricing and how maturity length and higher and lower coupon rates can affect bond prices when interests go up and down in the economy.

Answer 1

The effect of interest rates on bond pricing :

When the interests rates are high, bond prices fall and when the interest rates are low then the bond prices rise. Hence, there exists an inverse relationship between the bond prices and interest rates.

The bonds prices fall in times of higher interest rate because in times of higher interest rate the investors do not like investing in fixed interest paying bonds and as a result bond prices will fall.

The greater the maturity of the bond, the greater will be the effect of interest rate changes on the bond. So, when the bond prices fall, the prices of the bond rise by a greater amount. When the interest rate rises,then the bond prices rise by a greater amount, The bonds with the higher maturity has greater interest rate risk.

A bond will the lower coupon rate will face a higher interest rate risk, as the bond will the higher coupon will receive high coupon interest payments. The bond with the higher coupon rate, will receive more coupon payments and so the prices of these bonds fall less in times of rising interest rates.

So, bonds with the lower coupon rate has a higher interest rate risk, that is the prices of these bonds will fall more in times of rising interest rates.