When a corporation issues a bond, it has to pay a fixed and predefined rate of interest to bondholders for the duration of the bond. It means that even when the market rate of interest changes due global events, insight about inflation and various other factors, the rate of interest payable by the issuers of bond remains unchanged. Market rate of interest is also referred to as:
- effective rate of interest
- rate of discount
- desired rate
- yield to maturity
When there’s an increase in market rates of interest
Market rate of interest tends to go up when inflation is expected to go up. Because of that investors would like to be paid higher rate of interest. That’s because they fear that the amount they’ll get on maturity of the bond would have reduced purchasing power.
Let’s say that when the market rate of interest was 9% a company issued bonds priced at $1000, 000 @ 9% interest/annum. Since the market rate of interest was the same as the interest rate of bond, the bond would sell for 100,000.
Next, suppose the market rate of interest, after issuance of the bond, went up to 10 percent. The bond issuing authority will keep paying $9000/annum as per the terms of the bond, whereas the market would expect new bonds of $100,000 to pay $ 100, 00/annum. Since the interest that’s being paid by the existing bond is less than that being paid by new bond, the former’s value will decline.
So, we can conclude that the market value of an already existing bond will go down when the market rate of interest goes up and vice versa.
When there’s a decline in the market rates of interest
Let’s go back to the above example of a company issuing bonds priced at $1000, 000 @ 9% interest/annum when the market rate of interest was 9% and the bonds got sold for 100,000. Next, let’s say that the market rate of interest was reduced to 8%. In this case too the bond issuing authority would keep paying its investors $9,000/annum as per the agreement. However, the present market demand is for $8,000/annum only. Since the interest paid by bond is more than present market expectations, people will be willing to buy the bond, as a result of which its price goes up. This is in line with what we concluded above.
The market rate of interest is inversely proportion to the market price of a bond. Or we can say that the prices of bond and their yields go in contrary directions
So, a smart financial manager of a large company who can predict rates of interest would issue bonds before the market rates of interest increase and thus make smaller payments towards interest.
Likewise, a smart investor who can foresee the rates of interest would buy bonds before the market rates of interest start falling to get comparatively high rates of interest for the duration of the bond and dispose off bonds that he possesses before market rates of interest go up.