Bond Price and Interest Rates
Let us take an example of a three year SBI (State Bank of India) bond. The bond is rated AAA which
is the highest safety rating given by rating agencies. The terms of the bond are
Issuer: SBI
Rating: AAA
Issue date: 1st August 2011
Maturity period: 3 years
Maturity date: 1st August 2014
Face value of the bond: Rs 100
Coupon rate: 9.5%
Coupon payable: Annually on 1st August every year
Amount payable on maturity: Rs 100
If you invest in this bond and hold it till maturity you will receive 9.5% on your investment every
year for three years and at the end of three years you get back your original investment. The face
value of the bond is Rs 100 and if you invest Rs 100,000/- you get 1000 bonds (Rs 100,000/Rs 100).
The bond is listed on the NSE (National Stock Exchange) and is tradable. You can sell your holding
in the SBI bond partly or wholly. We will elaborate on buying and selling of bonds in later tutorials.
You do not want to hold the SBI bond for three years and after one year of investment you want to
sell the bond. Let us assume you sell the bond on the 1st of August 2012 after receiving the first
coupon payment of 9.5%. In your case you will receive Rs 9500 as you have invested Rs 100,000 in
the SBI bond.
What will you receive after one year? Let us take three scenarios 1) Interest rates are the same at
9.5%. 2) Interest rates have moved up by 100bps (1%) to 10.5% and 3) Interest rates have moved
down by 100bps (1%) to 8.5%. 1bps (basis point)= 0.01%
1.Interest rates are the same at 9.5%
Bond price = Rs 100. You get back your investment of Rs 100,000 (1000 bonds * Rs 100)
Total returns including interest received = Rs 109,500 or 9.5%.
2. Interest rates are higher by 100bps.
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Bond price = Rs 98.27 You get back Rs 98,270 (1000 bonds * Rs 98.27)
Total returns including interest received = Rs 107,770 or 7.7%
3. Interest rates are lower by 100bps
Bond prices= Rs 101.77 You get back Rs 101,770 (1000bonds * Rs 101.77)
Total returns including interest received= Rs 111,270 (11.27%)
We can see that if interest rates fall your returns are higher than the coupon returns while if interest
rates rise your returns are lower than the coupon returns. You should be buying three year SBI bonds
if you believe interest rates will fall and you should be investing in SBI fixed deposits instead of SBI
bonds if you believe interest rates will rise.
Bonds prices are inversely related to interest rates. The simple equation below gives you the
relationship.
SBI three year maturity bond with coupon of 9.5%.
Bond price = 9.5/(1+9.5%)^1 + 9.5/(1+9.5%)^2 + 109.5 /(1+9.5%)^3
where 9.5 is the coupon on face value of 100, 9.5% is the discount factor (or prevailing interest rates
for a three year maturity bond) and 109.5 is the coupon + face value received on maturity.
If you plug this equation in an excel sheet and change the discount factor from 9.5% to 10.5% or
8.5% you will see that the bond prices fall when interest rates rise and bond prices rise when interest
rates fall.
Zephyr Financial Publishers Pvt Ltd.
Registered Office: 13/701 NRI Complex, Nerul, Navi Mumbai - 400706. Mobile: +919819770641 E-mail: [email protected]