Bonds and interest rates

My girlfriend asked me this morning, why do bond prices fall as interest rates rise? Here's my extended answer, for those who are curious about such things:

First, let's say you DIJA Incorporated, and you decide you want to borrow some money (to invest in improving your fantasy football spreadsheet). You do so by selling bonds. In this case, you decide you will sell one $10,000 bond with a five year maturity, earning 7% interest. What does that mean? It means that, if Mr. Bond Investor buys the DIJA bond, he will:

1. Loan DIJA $10,000 today (by buying the bond)
2. Earn 7% interest on his $10,000 every year for five years
3. Get his $10,000 back in five years (when DIJA pays off the principal)

Second, where does that 7% interest come from? Well, lots of thing, but we can simplify: we'll say the DIJA-bond interest rate is made up of two components: the risk-free rate, and the DIJA "risk premium."

What is the risk-free rate of interest? Well, that's the interest rate that the U.S. government pays on its bonds – essentially, the safest investment you can make. That interest rate is set by the Federal Reserve Bank, through a complicated process I won't explain here. Let's say that the risk-free interest rate is 5% (in reality, it's much lower right now).

If the "risk free rate" is 5%, but a DIJA bond is paying 7%, that means that DIJA Inc. has to pay investors 2% more to invest in DIJA, rather than simply loan money to the US government. That 2% is the DIJA risk premium.

Keep rereading that until you understand it. Got it? Ok, let's move on.

So Mr. Investor decides to buy the DIJA bond (I'll explain why in a moment). Now, once he owns the bond, he doesn't necessarily have to keep it, right? He can sell it anytime he wants, as long as he can find another investor. That way, he doesn't have to wait the entire five years before getting his principal back. In this way, bonds are traded like any other financial instrument. Certain people do it so much, they are known as "bond traders."

Now, enter Federal Reserve Chairman Bernake, the man who controls interest rates. Let's say that, one week after Mr. Investor bought the DIJA bond, the Fed decides to lower interest rates. Big time. The Fed decides that, henceforth, the risk free rate should be a miniscule 1%.

Imagine what this means for companies that plan to issue bonds. Last week, they had to pay investors 5% plus whatever risk premium. Now, the risk free rate is only 1%. So DIJA Incorporated, for example, if it decided to issue another $10,000 bond, would only have to pay a 3% interest rate on the bond. By lowering interest rates, the Fed has made it much cheaper for companies to borrow money.

And now let's return to Mr. Investor. The DIJA bond he purchased last week is now paying an extra 4% than all future DIJA bonds, or any other company with a risk-premium of 2% – pretty sweet! In fact, it's so sweet that if Mr. Investor decides to sell his bond to someone else, he can demand they pay him a little extra for his sweet bond, since the Buyer will be getting an above-market rate of return. Hence, the bond price rallies as interest rates are lowered.

By the same logic, we can see what happens when the Fed raises interest rates too, right? If the Fed shoots interest rates to, say, 10%, now DIJA Incorporated will have to issue its new bonds at a whopping 12% interest rate. Mr. Investor, sitting there with a bond paying only 7%, now feels like sh*t. If he wants to sell his bond, he'll have to lower his price to compensate for the sh*t interest rate his bond is paying. So bond price fall as interest rates rise.