How Bond Interest Rates are Calculated

Bond interest rates are set on a near daily basis. The issuing organization evaluates its own financial situation to determine how much it can reasonably pay out on the bond while still sustaining growth and profits. Bonds are issued as a way for a business or organization to get a loan without seeking a lender. They use the money to grow, purchase, expand or even to pay down their own debt. They measure how much they need, how much profit they can expect, and then how much they may be able to pay. If these measurements change, the interest rate on bonds will change.

Interest Rate Decreases

When the interest rate on a bond decreases, it is generally less desirable. It will pay less over time. This is good for you, because you are holding a bond with a higher interest rate than that being currently advertised on the market. You can sell the bond for a profit or simply collect the higher rates. You purchased the bond at a good time.

Interest rates can decrease when the organization sees a drop in profits and does not think it will be able to continue to repay high rates. However, interest rates can also drop if the market on the whole slows down. In this case, nearly any stock or bond will be paying lower dividends. The value of the stock you are holding may see no real change if this is the case.

Interest Rate Increases

If the interest rate on a bond increases, the newly issued bonds will pay more than the one you are holding. This means the bond you are currently holding will drop in value. If you were to sell the bond, you would lose money on the sale. This is unfortunate for you, and you will likely find you purchased at a bad time.

Interest rates go up for individual as well as market reasons. If the organization has very high sales, sees unprecedented growth or simply wants to sell more bonds, it can raise the interest rate of each bond. Similarly, if the national prime rate goes up, the interest rate on a bond will have to go up to overcome losses due to inflation. For that reason, interest rates on bonds generally go up over time, barring a recession.

Bond Duration

If interest rates existed in a bubble, then this would be all you need to know. However, interest rates always need to be compared to the price of the stock. Take the example of an interest rate increase to compensate for inflation. When the interest rate goes up, the price of the bond also goes up. This means the bond you are holding could be sold for slightly less than the new bonds and you may still earn a profit.

The measure of price compared to interest on a bond is called duration. Duration is the calculation of how long it will take for a bond to pay back its true value. If the duration of a bond is stable, changes in interest rate are not as important.

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