Interest Theory and Bonds

By: EconomyWatch   Date: 14 October 2010

About The Author

EconomyWatch

The core Content Team our economy, industry, investing and personal finance reference articles.

EconomyWatch, Content Team

 

  • Dot Div
  •      



Interest Theory and bonds are inversely related in the sense that when the rate of interest decreases, it leads to automatic escalation in the prices of the bonds, and vice versa. This invites more investment on company bonds, leading to constant flow of working capital into these companies.

To clearly understand the relationship between interest theory and bonds, one needs to study it from the basic level. Bonds can be purchased either directly or through mutual funds. The process of buying bonds by customers involves offering loan to the issuer of those bonds, with the assurance of repayment of the principal amount after maturity of the bonds. In fact, it is the responsibility of the bond issuer to repay the periodic interest amounts to the buyers to compensate them for their investments. However, repayment made by the issuer is in accordance with the prevailing interest or coupon rates of the bonds, which rarely fluctuates. The issuance of fresh bonds is normally available with the respective interest rates, which are either accurate or close to the existing market interest rates. In an attempt to develop the macro-economic theory, John Maynard Keynes studied minutely, The inverse relationship between rate of interest and price of bonds can be best described through the concept of “Opportunity Cost”. Here, a continuous comparison goes on among the investors about returns on the recent investment on bonds with that of the returns they might derive investing somewhere else in the market. With the change in the market interest rates, the coupon rate of the bond becomes all the more lucrative to these investors, who then become almost prepared to pay for the bond itself.

Let us suppose that a buyer has purchased a bond at a particular rate of interest. In case the rate of interest escalates on a particular year, the bonds have to be sold at a lower cost, involving certain percentage of discounts. Similar will be the case if the interest rate falls below the bond’s actual coupon rate. At that time, the price of the bond will accompany a premium because it will have higher rate of interest than the available market interest rates.

Other factors responsible for making a bond lucrative are as follows:

  • The time period till the maturity of the bond
  • Whether the interest rate of the bond is taxable or not
  • The eligibility of the bond issuer
  • Possibility on the part of the issuer to repay the debt at the earliestHowever, fluctuations in the market interest rates occur frequently in today’s commercial world. The variation in the yield and prices of the bonds are mere effects of this change.



    • Dot Div
    •      

    Most Popular in Economic Theory

    Related Links
    blog comments powered by Disqus