In Part One, we discussed how the supply and demand for bonds impacts interest rates. In particular, we discussed how Quantitative Tightening (QT) was putting upward pressure on interest rates. In this part, we’ll discuss how changes in interest rates cause changes in the market value of bonds.
Let’s say you bought a new bond for $1,000 paying 5% or $50 annually. Now, what happens to the value of your bond if interest rates increase to 6%? There is no reason a buyer would buy your bond paying only 5% or $50, when he could buy another bond paying 6% or $60. But, the buyer would pay some amount of money to receive $50. You can roughly compute that amount by dividing the cash interest payment by the current rate, e.g., $50 divided by 6% equals $833. Thus, the value of your bond dropped $167 or 16.7% due to the 1% increase in interest rates.
Of course, there are always a few wrinkles. Remember that you would get the full $1,000 if you held the bond to maturity. Or, you could sell it now for $833, and the buyer would get the $1,000 at maturity. The closer the maturity date, the more the buyer is willing to pay.
The same principles apply if interest rates fall. Assume you bought that new bond for $1,000 paying 5%, and interest rates fall to 4%. The value of your bond increases to $1,250. ($50 divided by .04) That is a 25% capital gain from a 1% decrease in rates. Naturally, the closer to maturity, the less the buyer is willing to pay for it.
Since the supply and demand for bonds drive interest rates, which drives the value of your bonds, we will continue that discussion of supply and demand in Part Three.