There is an inverse relationship between the bond prices and the interest rates prevailing in the market.
This means if the interest rates are increased, the bond prices decrease, and vice versa.
Bonds are instruments of investment for the investors and an instrument to raise funds for the issuer.
You can read more about the basics of bonds here.
Bond Prices
The Price at which the bonds are purchased and sold in the bond market is called Bond Price. When the bonds are issued in the primary bond market, The bond price is the same as the face value of the bond.
How does the issuer decide the interest rate on bonds?
When an issuer issues the bond, three things are specifically mentioned:
Face value of the bond (.i.e. Bond Price)
The Interest rate on the bond (.i.e. the coupon rate)
The time period for which the bond is issued
When you (an investor) would subscribe to a bond, you would be required to pay the face value of the bond to the issuer and the issuer would pay the periodic interest (as per coupon rate) on the bond during the period for which the bond is issued.
Let’s say the “ABC” company has issued a bond that has a face value of Rs.1000, carrying a coupon rate of 8% per annum for 10 years.
If you want to invest in the bonds of the “ABC” company, you would pay Rs.10000, in return, you would get Rs.80 per year as interest for 10 years and after the 10th year, you would get your original investment. i.e. Rs. 10000
Now, in our above example instead of the “ABC” company, if the bonds are issued by the Government of India.
What would be the coupon rate on Government bonds?
It would be anything lower than 8% as issued by the “ABC” company.
But, Why?
It would be due to the fact that the riskiness of investment in the bonds of a private company would be more than that of the investment in government bonds.
The reason is obvious; the company may fail but the government may not.
The company would have to keep the interest rates on bonds on the higher side than the government bonds so as to attract investors, otherwise, the investors would invest in the government bonds.
Therefore, the rate of interest (.i.e. the coupon rate) on the government bonds would be less than the corporate bonds.
Now let’s say the central bank (in India RBI) increases the repo rate in the monetary policy meeting by 50 basis points. i.e. 0.50%.
What would be the interest rate (Coupon rate) if the “ABC” company wants to make a fresh issue of bonds?
The “ABC” company has to offer a higher interest rate (higher by 0.50% at least) than that of 8% which it offered in its previous issue of bonds because now the repo rate has been increased by RBI.
And you know that the repo rate impacts the interest rates across the entire banking system.
Does the rate hike by RBI affects the interest rates of already issued bonds?
The answer is “NO”.
There would not be any change in the interest rates of already issued bonds.
The coupon rates and the period of bonds are fixed at the time of issue of bonds which cannot be increased or decreased with any rate change by the central bank.
Impact of interest rate changes on bond prices
There are two types of bond markets:
Primary bond market:
The market where the bonds are initially issued by the issuer. i.e. when the ABC company would issue the bond to raise the capital ( same as IPO in the equity market) it would be called a Primary bond market.
Secondary bond market:
The market where the already-issued bonds are traded is called the secondary bond market.
If you have not subscribed to the initial offer of bonds, you would have to purchase the bonds from the secondary market if you want to invest in the company.
This is the same as when you do not get the allotment of shares of a company in an IPO then you would buy them from the stock market. i.e. the secondary market, once the shares get listed on the stock exchange.
To understand the impact of interest rates on bond prices recall two things as we discussed above:
>The coupon rate on already issued bonds does not change with the change in interest rates by the central banks.
>Bonds issued in primary markets are traded in secondary markets.
Let us take the example of government bonds with the following “assumed” facts:
Example – 1:
The government issued the bonds with a face value (.i.e. the price of the bond) of Rs.1000 per bond.
The coupon rate (Rate of interest on bond) is 8%
The period of the bond is 10 years.
If you are a subscriber to the above government bond, you would get Rs.80 per year up to 10 years and at the end of the 10th year (.i.e. at the time of completion of tenure of the bond) you would get back the original invested price of Rs.1000.
Now in between, the central bank increases the interest rate by 50 basis points (.i.e. by 0.50%).
If you want to trade/sell your government bond carrying the coupon rate of 8%
Would you be able to sell your government bond at Rs.1000 (.i.e. the amount at which you purchased the bonds) or at a higher price (because you want to sell your investments at profit?
The answer is no.
But, Why?
The reason is, nobody would want to buy your bonds carrying the coupon rate of 8% at Rs.1000 or higher because now the central bank has increased the rate of interest by 0.50%.
So if you want to sell your bonds, you would only find the buyer at the discount. i.e. at a price less than Rs.1000.
By this, we came up with the inference that if the interest rates are increased by the central bank then the bond prices of the already issued bond decrease.
Example – 2:
The government issued the bonds with a face value (.i.e. the price of the bond ) of Rs.1000 per bond.
The coupon rate (Rate of interest on bond) is 8%
The period of the bond is 10 years.
If you are a subscriber to the above government bond, you would get Rs.80 per year up to 10 years and at the end of the 10th year (.i.e. at the time of completion of tenure of the bond) you would get back the original invested price of Rs.1000.
Now in between, the central bank decreases the interest rate by 50 basis points (.i.e. by 0.50%).
Now if you want to trade/sell your government bonds carrying the coupon rate of 8%.
Would you sell your bonds at Rs.1000 (.i.e. the amount at which you purchased the bonds) or at a higher price?
The answer is, obviously at a higher price.
The reason is, now the interest rates are decreased by the central bank and your bonds carry higher interest rates.
Therefore, you would want to sell your bonds at a premium.
By this, we again came up with the inference that if the interest rates are decreased by the central bank the bond prices of already issued bonds increase.
To sum up example one and example two:
The bond prices are inversely related to the interest rate changes.
Why did the Silicon Valley Bank crisis happen?
Let’s say, the interest rate in the US market is 1%, therefore, the interest rate on the bond is decided at let’s say the same rate of 1%.
The banks invest in government bonds so as to be on the safer side because the government bonds are backed by a government guarantee and therefore carry low-interest rates but are issued for a long time period.
But the bonds of a company carry higher interest rates because the bonds of a company are not considered as safe as government bonds.
Now let’s say the Silicon Valley Bank has invested 1000 crore US dollars (the actual figure is in billions but 1000 cr is taken just for example) in government bonds and subsequently, the US fed has increased the interest rates to 2%.
Would any of the banks purchase the same bonds with 1% interest rates from the Silicon Valley Bank?
The answer is “NO”.
The reason is the interest rate prevailing in the market is 2% now and the bonds with Silicon Valley Bank carry an interest rate of 1%.
If anyone would buy these bonds, he would do so at a discount.
This means, a price less than 1000 crore so that he could get the profit equivalent to 2% as prevailing in the market
This means thereby the bond price decreases as the interest rate increases.
Now as you know that banks earn when the interest rates it is earning are greater than what it is giving to the customers.
Also, the bank remains financially strong when the deposits are more than the withdrawals.
Why the SVB is in crisis?
Silicon valley bank aka SVB does business primarily with startups. Startups are funded by venture capitalists (VC). When VC funding comes to a startup, the start-ups keep their money with the bank.
Here Silicon Valley Bank is the bank with the most startups in Silicon Valley.
SVB had huge deposits of startup money from 2021. Actually, there was an exponential increase in deposits in SVB through startups.
A bank earns when the rate of interest on deposits given by them would be less than what it is getting on the investments.
The SVB invests the startup’s money in US treasury securities at specified interest rates.
Meaning thereby that SVB is earning through the interest on US securities and paying to startups less interest than what it is earning.
Now US fed started to increase the interest rates from 2022 meaning thereby the value of treasury bonds in which the SVB had invested has started to decline because those bonds were low-interest rate bonds ( before 2022 the interest rates were less).
Now the interest rate on new bonds has increased and therefore the prices of bonds in which the SVB has invested have decreased.
So the investments of SVB were placed at a notional loss (a notional loss is a loss only in books that is not realised).
This notional loss started to pile up. But it was not affecting SVB because it was not a realised loss.
On the other hand, the real problem started when VC funding paused for startups.
If VC funding is not there in startups, the deposits of SVB started to decrease or even remained constant.
When the startup funding is reduced the startup started to withdraw their money at a faster rate to meet up their expenses.
So three things happened:
SVB not getting deposits
Withdrawals started by startups
Bond prices of already invested bonds by SVB started to decrease because of the increase in interest rates.
When the withdrawal rate is higher than the deposit rate a bank has to liquidate its investments to meet up the withdrawals.
Here the problem started for SVB.
To meet up the withdrawals the SVB was forced to sell the bonds at low prices (Since the bond price decreased due to an increase in interest rates).
Now on selling the bonds the notional loss of SVB became the realised loss and the cramp came in the structure.
Superbly explained!!!