22) Bond Price Moves Opposite to Bank Interest Rate And Bond Yields

22) Bond Price Moves Opposite to Bank Interest Rate and Bond Yields

This post is to show a simplified explanation on the effect of Interest Rate change on Bond price.
The bond price changes as the bond yield changes the opposite way.

Bank Interest Rate changes affect the Bond Yield the same way. 
Bank Interest Rate changes affect the Bond Price the opposite way. 

As a fund manager, the main task is to find a higher return with lower risk.
Let's say you have money and you have 2 choices, either Bond or Fixed Deposit. Where will you put your money?

If the current Fixed Deposit interest rate is 3%, then you would rather put in a bond that has a coupon rate of 5%. The 5% coupon rate will provide you with $50 per year as compared to earning $30 from the Fixed Deposit.

Bond Yield is defined as the Bond Income divided by Bond Price. 
Since the bond is giving $50 and the bond price is at $1000, the bond yield is 50/1000 = 5.00%.

Now, when fund managers know that the bond is giving $50, more fund managers will try to buy the bond. As the demand increase, the bond price will also increase.

From the table, the fund manager is willing to pay up to $1600 to get an income of $50 with the bond yield of 3.13%. It is higher than the Fixed Deposit rate of 3.00%.

However, if the Bank increased the interest rate to 4%, then it will be more attractive to put the money in the bank. So, to remain competitive, the bond price will drop to $1200 to get a bond yield of 4.17%. Bond yield has to be higher than Fixed Deposit return as bond has higher risk than Fixed Deposit.

If the Bank increased the interest rate to 6%, then it will be more attractive to put the money in the bank. So, to remain competitive the bond price will drop to $800 to get a bond yield of 6.25%.

In conclusion, when the bank Fixed Deposit interest rate increased, the bond yield will also increased. When the Bond Yield increased, the Bond Price will decrease.

The opposite occurs too. When the bank Fixed Deposit interest rate decreased, the bond yield will also decreased. When the Bond Yield decreased, the Bond Price will increase.

Bond yield will move same direction as interest rate. Bond price move opposite to Bond Yield. Therefore, Bond Price will move opposite to Interest Rate.


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