Skip to content

How interest rates affect bond prices and yield

This article appeared in the October 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

… and whether to choose fixed or floating rate securities.

Photo of Elizabeth Moran By Elizabeth Moran, Fiig Securities

Bond prices are influenced by many factors and you might think the biggest is changes to the Reserve Bank of Australia official cash rate. But the changes themselves are not the greatest factor; rather, it is market expectations of rate changes. These are often already factored into markets before an RBA announcement.

(Editor's note: To learn more about the features, benefits and risks of interest rate securities, take the free ASX Bonds and hybrids course).

The graph below, shows the historic relationship between the RBA cash rate and bank bill swap rate (BBSW). (The graph uses quarterly data. The RBA meets monthly and the cash rate can be altered every month, but there is too much data to show over a longer period.)

The two lines are often close but are rarely equal. For example, in March 2009, BBSW shows a positive outlook while the cash rate continues to decline from 3.25 per cent to 3 per cent, stays there, then rises sharply.

BBSW remains more optimistic than the cash rate for the three years from March 2009 to March 2012. From September 2011, the cash rate declines and BBSW lags the decline, possibly suprised by the severity of the cash rate cut by 0.50 per cent, from 4.75 per cent to 4.25 per cent, during the quarter.

Line chart showing the relationship between the RBA cash rate and bank bill swap rate (BBSW)
2007 to 2013

Line chart showing the relationship between the RBA cash rate and bank bill swap rate (BBSW) - 2007 to 2013
Source: FIIG Securities

Most effect on fixed-rate bond prices

When interest rates rise, fixed-rate bond prices fall; when interest rates fall, bond prices rise. Put simply, think of a see-saw in perfect balance (see the graphic below). Assume you buy a $100 bond with 10 years to maturity, which pays a 5 per cent interest payment (known as a coupon) delivering a required yield of 5 per cent. This is the starting point.

A rise in the interest rate to 6 per cent means that for the bond to have the same initial return of 5 per cent, the face value must reduce proportionally to $92.56 so that the see-saw remains balanced. The reverse is also true. If rates fall to 4 per cent, the bond price must increase to $108.18 to maintain the initial 5 per cent return.

This is the basic inverse relationship between interest rates and fixed-rate bond prices. Short-term investors are able to renegotiate interest rates after short periods. However, a fixed-rate instrument with a predetermined maturity value that has already been fixed, can only reflect a change in interest rate by lowering or raising the price paid for it.

The required interest rate will change based on factors specific to the security; for example, because the perception of its risk might have changed or the interest rate being offered on other securities has changed.

Therefore, a change in underlying interest rates as a result of RBA activity will have an effect on the price of fixed-rate bonds.

How changing interest rates impact bond prices diagram

How changing interest rates impact bond prices diagram

Source: FIIG Securities

It is essential to understand that bonds have two characteristic: income and capital gain or loss, and most people tend to concentrate only on any potential income. Importantly, it is the capital gain or loss that performs an insulation function for your portfolio. For this reason, fixed-rate bonds are an essential part of a balanced portfolio as they help to reduce the volatility of returns in divergent growth scenarios.

Floating-rate notes are more capital stable

Investors can choose to invest in variable-rate bonds (floating-rate notes) so that interest payments (coupons) reflect changes to market interest rate levels. These bonds are more capital stable in that the coupons they pay rise and fall with interest rates, and the bond price is not effected to the same degree as a fixed-rate bond when interest rate expectations change. Floating-rate note coupons are tied to BBSW and usually pay a fixed margin over (or under) the benchmark. These bonds are more attractive in a rising rate environment.

Therefore, a change in underlying interest rates as a result of RBA activity (and as a result of market movements in the yield curve) will have an effect on the price of fixed-rate bonds and, to a lesser extent, the price of floating-rate notes.

Three issuers with fixed and floating bonds

Considered these three different issuers, each with fixed-rate and floating-rate bond issues.

Dalrymple Bay Coal Terminal, near Mackay in Queensland, is the world's largest coal export terminal. It has fixed and floating bonds available in $10,000 parcels (minimum total $50,000). The first row in the table below shows the fixed-rate bond has less than three years to run. When the bond was first issued, the coupon was 6.25 per cent based on a $100 face value. 

Issuer Call date Maturity date Coupon Coupon type Capital structure Yield to maturity Running yield Capital price Face value Capital price
Dalrymple Bay Coal Terminal 09/06/2016 6.25% Fixed Senior Debt 4.79% 6.03% 103.660 $10,000 $10,336
Dalrymple Bay Coal Terminal 09/06/2021 0.30% Floating Senior Debt 6.21% 3.21% 89.651 $10,000 $8,965
National Wealth Management 16/06/2016 16/06/2016 6.75% Fixed Lower Tier II 4.86% 6.44% 104.750 $10,000 $10,475
National Wealth Management 16/06/2016 16/06/2016 0.63% Floating Lower Tier II 5.14% 3.33% 96.400 $10,000 $9,640
Vero Insurance 07/09/2015 07/09/2025 6.15% Fixed Lower Tier II 4.95% 6.02% 102.200 $10,000 $10,220
Vero Insurance 07/09/2015 07/09/2025 0.70% Floating Lower Tier II 5.35% 3.39% 96.650 $10,000 $9,665

Source: FIIG Securities/ Bloomberg
Prices accurate as at 23 September but subject to change.
Bonds available to retail and wholesale clients. Minimum initial spend is $50,000. Bonds can be purchased from $10,000 face value parcels.

However, since the bond was issued, market expectations of interest rates have changed and investors are now prepared to pay more than the $100 face value; in fact, they will pay $103.66, which means the effective interest rate comes down to 6.03 per cent if you hold the bond for a year. If you hold the bond until maturity, when you will receive $100 back, you will face a capital loss of $3.66 ($103.66 less $100) and this is factored into the yield to maturity of 4.79 per cent.

On the other hand, Dalrymple Bay Coal Terminal also has a floating-rate bond (the second row in the table) that pays a coupon of BBSW plus 0.30 per cent with a maturity of June 2021, more than seven years to run. The running yield or income on the bond is low at 3.21 per cent, but so is the capital price of $89.65.

Investors will make a capital gain of $10.35 if they hold this bond to maturity. Thus the floating-rate bond has a higher yield to maturity than the fixed-rate bond of 6.21 per cent.

Both the National Wealth Management and the Vero Insurance bonds show higher running yields on the fixed-rate bonds and lower yield to maturity when compared to the floating-rate note equivalents.

Fixed or floating?

When comparing a fixed-rate and a floating-rate bond by the same issuer, investors must weigh:

  1. Their future expectations of interest rates. Further declines should see the price of fixed-rate bonds rise, so may lead to capital gains. But the opposite is also true. In a rising rate environment, floating-rate notes with interest tied to BBSW are preferable as your interest income should rise, as should the price of the bond as demand increases.
  2. The term to maturity. A longer term will increase uncertainty regarding repayment, so the return should be higher.
  3. Whether income or capital gain is more important. A retiree seeking higher income would, using this example, buy the fixed-rate bond and possibly seek to sell when its price starts to decline as interest rates increase or it nears maturity.

Finally, a couple of points to remember:

  1. While bond prices move, generally investors will be repaid the $100 face value at maturity and their returns will be positive over the life of the bond, even if they make a capital loss on maturity. Investors are compensated by higher-than-expected interest payments through the life of the bond.
  2. It is a good strategy to lock in high income in a low or declining interest rate environment. A good broker will be watching the market and help you decide the right time to sell.

About the author

Elizabeth Moran is Director of Education and Fixed Income Research at FIIG Securities, a specialist fixed-income broker. She has been with FIIG for five years. Her previous experience includes positions at Rapid Ratings, NatWest Markets and BP Oil in London, and Commonwealth Bank.

From ASX

ASX Bonds explains the features, benefits and risks of these securities. 

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

© Copyright 2014 ASX Limited ABN 98 008 624 691. All rights reserved 2014.

Market news

Source: Source DowJones View all Market news