Does a Bond Price Adjust to Earn the Same Interest When Market Interest Rate Changes?
March 7, 2010 | In: Stocks and Bonds
I’ve been told that the prices of the bonds is adjusted for the market interest rate. I tested this with an example where the coupon rate changes and it worked. However, when I tested the changes in market interest rate, the bond price does not seem to adjust to earn the same interest in the market interest rate. Am I doing something wrong or is supposed to be so because they have are receiving the same payments (coupon rate x same same principle)? Thanks
5 answers
jeff410
March 8th, 2010 at 12:26 am
When interest rates change bond prices should change to yield the same as other bonds of the same risk.
Traci R
March 8th, 2010 at 12:50 am
Yes, the price of a bond will adjust so that the yield (rate earned) on the bond is equal to that of bonds of comparable risk. So when rates fall, the price rises, and when rates rise, the price falls. The price of the bond should always be equal to the bond’s true value, which you can calculate as the present value of all cash flows associated with the bond, discounted to the present at the market interest rate (for corporate bonds, the “market interest rate” would include a spread to compensate the investor for default risk).
picador
March 8th, 2010 at 1:40 am
Yes, the bond market is supposed to work according to “Present Value.” Assuming that the bond is sound, it will mature for its face value. If you discount the face value at a lower rate that prevailed previously, then the bond will have a higher value, and vice versa. Reasons I can think of for this formula not working are (a) the rating of the bond’s security (e.g. Moody’s) has changed, or the marketeers are just not paying attention.
Michael T
March 8th, 2010 at 2:16 am
This may work for treasuries since the risk remains stable and may not work for municipal or corporate bonds.
Also since the market value of the bond rises or falls inversely with the yield, there will be either a capital gain or loss at maturity of the bond. Therefore the yield of a 2.75% or 3.00% coupon bond with the same maturity will not be exactly the same due to the differences in capital gains or loses at maturity.
irish87a
March 8th, 2010 at 2:19 am
Remember that your coupon rate will not change (unless you have a floating rate bond/note). The price and market value of your bond will change based on the risk level of the bond issuer compared to treasuries, the maturity date, and any caveats to the bond.