Interest rates and Bond prices

Okay, so in any country, when the central bank increases the interest rate (known as the Repo rate), the prices of bonds in general fall.

Bond prices have an inverse relationship with interest rates

Here’s why:

Bonds give an interest to their investors, known as coupon. The coupon, once declared, generally doesn’t change, and is calculated on the face value of the bond (which like in the case of stocks, is different from its market price).

The calculation of coupon considers a lot of factors. To put it extremely simply, coupon of a bond consists of a lot of components. Of these components, Repo rate is an important one.

Repo rate is the rate at which banks borrow money from the central bank when they need to. And when the central bank increases the repo rate, new bonds that are issued will automatically have a higher coupon, since repo rate forms a part of the coupon calculation.

Now, bonds, like stocks, are traded in the bond market. So if the central bank increases Repo rates, this means that new bonds which are issued, will be more lucrative for investors, because they offer a higher coupon. This, in turn, means that older bonds which offer lesser coupon will be less lucrative, and therefore get cheaper and trade for a lesser price.

Alternately, if Repo rate decreases, new bonds will offer a lower coupon, and existing bonds, since they have a higher coupon, become more valuable and therefore increase in price.

Essentially, that’s how bond prices are impacted by Interest rate changes in the country.