What Is the Connection between Interest Rates and Bond Valuation?

Steven Symes

Market interest rates and bond valuation fluctuate at the same time during the life of the bond as interest rates affect the bond’s value. The relationship between market interest rates and bond valuation at a given period of time is inverse. In other words, when interest rates rise the value of bonds falls, but when interest rates drop the value of bonds rises. Bonds have a significant amount of interest rate risk because their value is tied to interest rate fluctuations.

Man climbing a rope
Man climbing a rope

When companies or governments need additional revenue, they might issue bonds that members of the public can purchase. A bond has a face value, or the amount of money you must invest when you purchase the bond. The bond also has an interest rate as well as a term, or how long the bond lasts as well as when interest payments are made. Some bond holders receive an interest payment quarterly or yearly, while others do not receive any payouts until the bond matures.

The relationship between interest rates and bond valuation can be useful to investors. Since the interest rate of bonds is normally constant, which investors use to calculate how much of a profit they will earn once the bond matures. When market interest rates rise, the fixed interest rate of a bond that was attractive before becomes less enticing to investors. Investors in such a market can put their money into other ventures and take advantage of the high interest rates to multiply their money more aggressively.

Bond valuations must change to accommodate fluctuations in a market’s interest rates. When interest rates rise, making investing in the bond not as relatively profitable of an investment, the company must lower the face value to entice investors. If the market’s interest rates drop, demand for the bond rises and so does the face value.

Investors should be aware enough of the relationship between interest rates and bond valuation to know that bonds carry a significant amount of interest rate risk. If an investor puts his money into a bond and then the interest rates increase, he cannot use that money to earn more interest at the higher rate. When the bond has a short term, it does not present as much interest rate risk as bonds with a long term. During a long term, the market interest rates could rise significantly, while during short terms rises in interest rates are not likely to be as large. Zero coupon bonds pose even more interest rate risk, since investors do not receive payments until the bond matures, not allowing them to invest any portion of the money into financial tools when interest rates increase.

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