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This relationship is expressed for a semiannual coupon bond by the following formula:. Par Bonds A bond is considered to be a par bond when its price equals its face value. This will occur when the coupon rate equals the required return on the bond.
The Relation of Interest Rate & Yield to Maturity | Finance - Zacks
The opposite is true as well: When bond prices rise, yields in general fall, and vice versa. However, other factors have an impact on all bonds.
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A rise in either interest rates or the inflation rate will tend to cause bond prices to drop. Inflation and interest rates behave similarly to bond yields, moving in the opposite direction from bond prices. The answer has to do with the relative value of the interest that a specific bond pays.
Bond Price Volatility and Bond Duration
Rising prices over time reduce the purchasing power of each interest payment a bond makes. Inflation also affects interest rates. The Fed takes an active role in trying to prevent inflation from spiraling out of control.
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- Interest Rates.
When the Fed gets concerned that the rate of inflation is rising, it may decide to raise interest rates. To try to slow the economy by making it more expensive to borrow money. For example, when interest rates on mortgages go up, fewer people can afford to buy homes. That tends to dampen the housing market, which in turn can affect the economy. When the Fed raises its target interest rate, other interest rates and bond yields typically rise as well. New bonds paying higher interest rates mean existing bonds with lower rates are less valuable. Prices of existing bonds fall.
An overheated economy can lead to inflation, and investors begin to worry that the Fed may have to raise interest rates, which would hurt bond prices even though yields are higher. Interest rates and bond prices have an inverse relationship; so when one goes up, the other goes down.
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 answer lies in the concept of opportunity cost. 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, remember, is fixed—becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself.
The Bond Pricing Formula
Let's look at an example. After evaluating your investment alternatives, you decide this is a good deal, so you purchase a bond at its par value: What if rates go up? Now let's suppose that later that year, interest rates in general go up.
What if rates fall? It would be priced at a premium, since it would be carrying a higher interest rate than what was currently available on the market.
Of course, many other factors go into determining the attractiveness of a particular bond: But the important thing to remember is that change occurs in market interest rates virtually every day.