When it comes to how interest rates affect bond prices, there are three cardinal rules:


1- When interest rates rise—bond prices generally fall.
2- When interest rates fall—bond prices generally rise.
3- Every bond carries interest rate risk.

Interest rate changes are among the most significant factors affecting bond return.
To find out why, we need to start with the bond’s coupon. This is the interest the bond pays out. How does that original coupon rate get established? One of the key determinants is interest rate that banks with excess reserves charge other banks that need overnight loans.


The central bank sets a target for the rate and maintains that target interest rate by buying and selling treasury securities.

When the central bank buys securities, bank reserves rise, and the rate tends to fall. When the central bank sells securities, bank reserves fall, and the rate tends to rise.

While this interest rate isn’t directly controlled by the central bank, it effectively controls it through the buying and selling of securities. The inter-bank rate, in turn, influences interest rates throughout the country, including bond coupon rates.


>>Example: Fed Fund rate, and the LIBOR.


What happens to the Treasury bonds you bought a couple of months ago at the lower interest rate?

They’re not as attractive. If you want to sell them, you’ll need to discount their price to a level that equals the coupon of all the new bonds just issued at the higher rate. In short, you’d have to sell your bonds at a discount.

It works the other way, too. Say you bought a $1,000 bond with a 6 percent coupon a few years ago and decided to sell it three years later to pay for a trip to visit your ailing grandfather, except now, interest rates are at 4 percent. This bond is now quite attractive compared to other bonds out there, and you would be able to sell it at a premium.



You often hear the term basis points—bps for short—in connection with bonds and interest rates.

A basis point is one one-hundredth of a percentage point (.01). One percent = 100 basis points.

One half of 1 percent = 50 basis points. Bond traders and brokers regularly use basis points to state concise differences in bond yields.



Smart bond investors pay close attention to key or “leading” economic indicators, primarily watching for any potential impact they may have on inflation and, because there is a close correlation, interest rates. Various branches of the federal government keep tabs on many, but not all, of these leading indicators. Here are a few useful online resources:


> U.S. Census Bureau’s Economic Briefing Room and Economic Calendar

> U.S. Department of Labor, Bureau of Labor Statistics

> The Conference Board’s Economic Indicators

> The Fed’s calendar of Federal Open Market Committee (FOMC) meetings. The FOMC sets certain interest rates that are used by others in the bond market to determine all other interest rates