[Derivative ABC] The Correlation Between Interest Rates and Bond Prices

[Asia Economy Reporter Jihwan Park] When reading newspaper articles, you often come across the phrase that bond yields and prices move in opposite directions. However, this raises the question: if interest rates rise, shouldn’t the interest received also increase, thereby raising bond prices?

The reason why interest rates and bond prices move inversely is that the amount received at bond maturity is already fixed. If the amount to be received at maturity is fixed, the only way to increase yield is to buy the bond at a lower price.

For example, bonds have a structure where interest is paid periodically and the principal is repaid at maturity. Suppose a bond with a principal of 100 and an interest rate of 20% pays interest every three months. You would receive 5 (interest) 5 (interest) 5 (interest) 5 (interest) every three months and then receive the principal of 100 at maturity. If the interest rate is 2%, you would receive 0.5 (interest) 0.5 (interest) 0.5 (interest) 0.5 (interest) and then receive a principal of 98.

A bond that will pay 100 in one year can be purchased for about 80 when the market interest rate is 20%. If the interest rate is 2%, you can buy it now by paying 98. This is because the structure is to receive 2 in interest over one year and then 100 at maturity. Ultimately, because the amount to be received is fixed, the higher the interest rate, the less you need to pay to buy the bond.

In conclusion, rising interest rates mean bond prices fall. This is because the value of the money to be received in the future decreases accordingly.

Currently, we are in a period of ultra-low interest rates. Since bond prices have risen as interest rates have fallen, it can be said that it has been a bull market for interest rate derivatives. In other words, buyers of government bond futures and bond futures have enjoyed a profitable market. If low interest rates continue in the future and even move into negative territory, buying could be a favorable investment strategy.