How Interest Rates Affect Bond Prices and Yields?

‘Sasta gold aur sasta bond kabhi nahi chodna chahiye’

There was a college senior of mine who discovered a 5-year corporate bond offering 5.8% returns. He thought that it would work as an extra income in the long run, so he invested ₹3 lakh into it. 

As I always say, children, ‘Andhon ki tarah invest mat karo!’, and that is what my senior did. He invested his money without checking the direction of interest rates.

Three months later, the RBI hiked the repo rate from 6% to 7%. New bonds started giving 7.5%. Now, if Rohit tried selling his bond before maturity, buyers weren’t interested. Why? Because they could earn more elsewhere. His bond's market value fell to ₹2.75 lakh.

Here’s how that wrong call cost him:

Had Rohit waited a bit or chosen a floating-rate bond, he could have gained more and saved himself the loss. Bonds do not behave like FDs. Their prices change depending on the interest rate environment. But not everyone has a junior who could guide you like I did for my senior. Wrong!

This is the blog that you needed. Once you understand how interest rates affect bond prices and yields, you will understand the difference between high returns and stability.

The Inverse Relationship Between Interest Rates and Bond Prices

Ruqsaar bought a bond that pays ₹7,000 annually on a ₹1,00,000 investment. New bonds started offering ₹10,000 annually for the same investment. Her bonds became less attractive, meaning that to sell them, she would need to provide a discount. 

This is because when interest rates rise, the prices of existing bonds fall, and vice versa. It's like selling an old phone when a new model is out; you have to lower the cost to make it appealing. ‘Ab samjhe miyyan.’

Read More – IRFC Bonds

For example, Rahul bought a ₹1,00,000 bond at 7% annual interest. 3 years later, new bonds offered 8.5%. To sell his old bond, Rahul had to discount it to ₹94,500. Buyers preferred ₹8,500 per year over ₹7,000.

The rising rates dropped his bond’s value by ₹5,500. Let’s have a quick recap of both bonds and their values in the table given below:

Discount boosts yield to match market rate

Price Drop (%)

5.5%

0%

Rahul loses value due to the interest rate hike

What Is Bond Yield and How Is It Calculated?

When you invest in a bond, you're practically lending money to an entity (like a government or corporation). In exchange, you will get periodic interest payments and the return of the bond's face value at maturity. The bond yield represents the return you earn on this investment. There are two common types:

• Current Yield: This shows the annual return based on the bond's current price. Its formula is as follows:

Current Yield = (Annual Coupon Payment / Current Market Price) × 100

• : This shows the total return if you hold the bond until it matures. Its formula is as follows: