1. Understanding why Bond prices fall
when Interest rates go up

2. Say I bought a laptop for Rs 1 lac – the
latest model.
One month later my friend gets a better
model with more features
for Rs 1 lac

3. I go back to the shop from where I had
purchased the laptop to complain saying
that the deal was unfair for me.
To my surprise I realize that the same
laptop which I had purchased a month back
for Rs 1 lac is now retailing at Rs 95,000

4. Now why did this happen?

5. Clearly, two things happened.
2)The manufacturer first sweetens the offer adds
some new features at the same price.
3)Therefore he gives a discount on the earlier model
and brings down its price from Rs 1 lac. to Rs
95,000
In a manner of speaking we can then say that the
moment the market makes a BETTER or HIGHER
offer at the same price, the price of the older version
goes down.

6. In the same manner when the market offers
BETTER or HIGHER interest rates, then the
PRICE of OLDER VERSION of bonds with
lower interest rates comes DOWN.

7. Similarly when interest rates are expected to come
down, prices bonds yielding higher interest rates
would climb up.
This can be compared to a scenario when a
manufacturer of a car strips down some of its
features in order to maintain prices. In such a case
the original model would be priced at higher price

8. Let’s understand this with a numerical example:-
A bond is issued for Rs.10, 000 for five years with a
5% coupon or interest rate, paid every six months.
Then interest rates in the market rises to 6%.
If you want to sell this bond, who would buy it when
it is paying 1% below market rates (5% vs. 6%)?
You have to sweeten the deal so that the buyer gets
at least market rate for the bond.
You can’t change the interest rate on the bond.
That’s fixed at 5%. You can, however change the
price you will take for the bond.

9. Let’s understand this with a numerical example:-
The annual payment of Rs.500 (Rs.10, 000 x 5%)
must equal a 6% payment.
Doing the math, you discover that the face value of
the bond must be discounted to Rs.8, 333/- so that
the Rs.500 fixed payment equals a 6% yield on the
buyer’s investment (Rs.8, 333 x 6% = Rs.500).
If interest rates went down instead of up, you could
then sell your bond at a premium over face value
because the fixed interest rate would be higher than
the market rate

10. Hope this story has clarified why one should invest in long duration
bonds when interest rates are expected to fall and short duration
funds when interest rates are expected to rise
Please give us your feedback at
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