While observing bond prices in the market, some important relationships have been noted that always hold true. A financial professional, possessing knowledge of these relationships, can quickly estimate outcome of the prices of bonds in the market.
These relationships (facts) have impact on current market value of the bond and can be enlisted as follows;
- Market interest rate vs. Price of bond
- Coupon rate & Required rate of return vs. Price of bond
- Maturity period vs. Price of bond
- Maturity period vs. Interest rate risk
- Coupon rate vs. Interest rate risk
The interest rate prevailing in the market (which happens to be investor’s current required rate of return) is inversely proportional to value of the bond. In other words if market’s interest rate increases, the value of the bonds will decrease and vice versa.
If investors required rate of return is more than coupon rate of the bond then bond’s price in the market will be lower than its face value. However if required rate of return is lower than the coupon rate then the price of the bond in the market will be higher than the Par / face value of the bond.
As the maturity date of a bond approaches its market value (price) tends to be equal to its face value. In other words the bonds which are about to mature will be traded in the market approximately on their par value.
Interest rate risk refers to fluctuation in the price of bond held by the investor. For example an investor purchases a bond on face value say $ 100. If interest rate increases in the market, price of bond will decrease below the face value (first relationship), thus investor who purchased the bond on $ 100 will sustain loss. Risk of this loss is always present and known as interest rate risk.
It has been observed that bonds with longer maturity periods are more prone to this interest rate risk as compared to shorter maturity period bonds. In other words a bond with maturity period of 30 years is more risky than a bond with 10 years maturity period in respect of interest rate risk.
The value of bond with higher coupon rates is less prone to changing interest rates than the value of bonds with lower coupon rates. Sensitivity of bond's value, in respect of interest rate risk, is dependant not only on maturity period but also on coupon rate. Higher coupon rate bonds’ are less risky as compared to the bonds with lower coupon rates.