The financial market has been a buzz with activity over the past few months. From the Jamaica Debt Exchange (JDX), movement in the prices of the Global bonds, falling interest rates to the recent changes in the exchange rate. Let’s take a closer at the effects of movements in interest rates on bond prices.

What history has taught us is that there is relationshp between bond prices and interest rates. What this means is that when interest rates go up, bond prices go down and when interest rates go down, bond prices go up. Bonds provide some element of stability that offsets some of the volatility of stocks however they are vulnerable to economic changes that can undermine their value. The biggest economic threat to bonds tends to be rising interest rates.

When new bonds are issued, they typically carry coupon rates at or close to the prevailing market interest rates, the question is how does the prevailing market interest rate affect the value of a bond you already own or a bond you want to buy from or sell to someone else? The changes in interest rates affect one’s portfolio only if bonds are held for investment purposes, that is, if clients intend to buy and sell bonds as they would stocks. Investors constantly compare the returns on their current investments to what they could get elsewhere in the market. As market interest rates change, a bond’s coupon rate – which is fixed, becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself. Let’s look at an example.

A bond is issued at $10,000 face value for five years with a 10 per cent coupon rate (interest rate), paid every six months. Let’s say interest rates fall to 9.50 per cent. Given that the interest rate on the instrument is fixed if you were to sell the bonds you could sell at a price higher than face value. Investors would be willing to pay a higher price for an instrument offering a higher rate (10.0 per cent) than what the market is currently offering (that is 9.50 per cent). Therefore as interest rates fall the price of the bonds will rise.

The same reasoning works in reverse too, if interest rates were to rise to 10.50 per cent. (using the same example above). Investors would prefer to buy the new bond being offered at a coupon rate of 10.50 per cent . Because of this, any of the investors who want to sell their 10.0 per cent bonds must give buyers an incentive to buy – meaning they must offer their bonds at a lower price.

This inverse relationship of course does not affect clients whose intentions are to hold the bonds until maturity. Changing interest rates have no effect on the performance of existing bonds unless clients plan to buy or sell them in the open market.

Becaues of the interest rate risk, bonds with longer terms are more risky than bonds with shorter terms. If you plan to trade bonds, be sure that you understand the interest rate risks involved and how holding long-term bonds increases that risk.

Dian Blackwood is a personal financial planner with Sterling Asset Management Ltd. Sterling provides medium to long term financial advice and instruments in U.S. and other world market currencies to the corporate, individual and institutional investor.

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