Interest rates are of significance to all incumbent and potential investors with regards to bond markets. Prevailing rates of interest at any given point of time is the single most crucial factor in determining and understanding the fluctuations in corporate bond rates and the effect it has on investors.
Interest rates change due to a lot of reasons within an economy. Causes could be inflation, changes in supply and demand of credit, credit risk of one economy compared to that of the other, global economic scenario and a lot more. The bond market typically reacts rather strangely to even positive news on the economy. That can be explained by the fact that the bond markets are directly hit by any increase in inflation. Higher inflation would mean that the returns on the “fixed income” that bond investors live on, are greatly reduced. Strangely enough, a weak GDP or higher rates of unemployment reduces inflation and assuages an average bond investor's fear of diminishing returns on his income from bonds.
How Interest Rate Fluctuations Can Affect You
One of the primary rules one has to understand about bond market is that the 'bond prices” move in opposite direction of the Interest rates (as depicted by the Image below) When Interest rates rise, bond prices fall. When interest rates fall, bond prices rise.
[Img Courtesy: franklintempleton.com]
When the interest rates go up, new bonds are issued by organizations that still find the need to raise more money to meet their increasing financial needs. They would pay the requisite prevailing interest rate, which would automatically make the older bonds that they have issued (at a much lower interest rate) less lucrative, causing a fall in their prices to make up for the difference.
Similarly, bond prices go northwards when the interest rates plummet, because the bonds which were issued prior to the hike in the Interest rates are now more lucrative than the ones being issued after the fall in interest rates (they pay less yield now).