Level | Advanced

What are Interest Rates? How do interest rates affect bond prices?

Interest rates are set by central banks to dictate the cost of money, ensure monetary stability and to a certain extent, control the rates at which their national currency is traded at. In India, the body that is responsible for setting interest rates is the central bank of the country, the Reserve Bank of India. Central banks attempt to behave in an economically positive manner to ensure that inflation rates and currency rates stay within set targets, and promote economic growth.

The Reserve Bank of India (RBI)-set interest rates are applicable to banks borrowings from and lending to the central bank through the repo and reverse repo transactions. Interest rates on government securities (G-secs) have a limited correlation to the RBI announced rates. The bond market takes cues from the RBI rates and prices the G-secs considering also the demand-supply position and likely direction of RBI rates in the near future. G-secs are backed by the sovereign guarantee of the central government and hence may not involve a large mark-up over the RBI determined rates.

Other public sector and private sector bonds are however considered more risky than the G-secs which means they would have to pay out a higher interest to attract investors. The extra interest rate would depend on the risk profile of the institution issuing these bonds and other relevant factors of the bond market.

Correlation of bond prices to interest rates

Bond prices have an inverse correlation to interest rate movements, that is, if market rates increase after a bond issue, the price of these bonds declines, and vice-versa. Let’s understand this with an example. Let’s say ABC Ltd had issued bonds of face value Rs 100 for an interest rate (also called as coupon in bond parlance) of 10 per cent per annum a year ago. Interest rates have generally been on a decline in the past year and hence, ABC Ltd issues fresh bonds at 9 per cent today. Now the price of the old bonds which were issued at 10 per cent coupon would appreciate above its face value, to say Rs 105. This is because the old bonds are now priced with regard to the present interest rate. Investors receive the same coupon of Rs 10 from the old bond even in the present softer interest rate scenario and hence are willing to pay a premium over its face value.

The extent of impact on the bond prices depends on the coupon rate and the residual maturity of the bond. Lower coupon rate bonds are more impacted than higher coupon rate ones for the same movement in interest rates. Similarly, longer residual maturity (years remaining for the bond to mature) bonds are impacted more than shorter maturity ones.

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Key Takeaways

  1. Interest rates are set by central banks and are a key mechanism to control the cost of money.
  2. Interest rates may be changed in the light of specific economic data such as inflation rates, growth forecasts and currency rates.
  3. Bond prices act inversely to interest rate movements.