Could you explain this in simple English? I don't have any training in economics, but I want to understand. For example, why is it that the interest rate and the price move in opposite directions? I thought the interest rate was the price.Excellent idea! The first thing to understand is what exactly a bond is. A bond is just a debt. If I am selling bonds, what I'm really doing is borrowing money. What I am selling is the promise to pay a certain amount of money at a set date in the future, and I am selling that for a price less than the amount I will pay at the future date.
So, say I want to borrow some money for one year. I offer a $1000 bond for sale at, say, $990. If you want to lend me this money, you agree to give me $990 now, and I agree to give you $1000 in one year. This difference, $10, is what determines the interest rate, in this case, 10/990 = .01 = 1% (good deal for me!). This is the price I must pay to borrow this money. What is it that determines this interest rate, that is, what determines the difference between what I get now and what I have to pay in a year? For simplicity, we'll just say that it's mostly based on what you, the lender, or the buyer of my bond, think of my likelihood of paying you back, and the difference between what the money is worth to you today versus what it is worth to you in one year (the "time value of money").
The other way to look at a bond is from the buyer's perspective. As we've already said, the person buying a bond is really lending money to the person selling the bond. As we saw above, the interest rate is the price the bond seller (money borrower) must pay in order to borrow the money. From the perspective of the bond buyer (money lender), the interest rate is the "rate of return" on the money loaned. Think of it this way: you've found yourself with an extra $990. What do you want to do with it? You could put it in a checking account, where in one year you will still have $990, no more, no less. You could buy something that you think will go up in value, like stock, or a commodity like gold or oil. If you do that, you're hoping that you'll be able to sell it in the future (say one year) for more than you bought it for. On the other hand, you could also lose money if whatever you buy goes down in value. So on the one hand (checking account) you have virtually no risk of losing your money, but absoluely no chance of growing the money. On the other hand (stock, commodity) you have the chance to make a lot of money, but also the chance of losing a lot (as much as all of it, if the company you buy stock in, for example, goes bust). A bond is a sort-of middle-of-the-road between those two extremes. You will earn more than a checking account, but less than best-case stock or gold purchases. The risk is less than that of stocks or commodities, because you will get back what the bond says you will get back, unless the company goes bust. (With a stock, it could lose value if the company is struggling, but still in business.)
So this is pretty straightforward, right? I want to borrow some money, and you have some lying around, so we agree a price and we're both happy, right? Not so fast! From my perspective, not much can happen from here. I will pay you in one year. But this is not the end of the story for you. You've lent me your extra funds for one year, mainly because you didn't expect to need them. But now, six months into our agreement, suddenly you need your money! D'oh! What are you going to do? I don't have to pay you back, and in the world of high finance, I'm not going to do anything I don't have to. That gives you only one real option: find another person that you can sell my debt to. Maybe in our little miniature model of high finance, there is a third person. Call him Hans. Hans also has some extra cash, but he doesn't want to tie it up for a whole year, so he's been keeping it in a checking account earning nothing. Now you come along with an offer to Hans: buy this bond with only six months left before the payoff. You need your money back now, and Hans gets a productive place to put his money for six months.
Since you gave me $990 in exchange for me giving you $1000 in one year, you tell Hans that, since it's now six months into that year, that you'll sell him my bond for $995. This way you get the same interest rate that you were expecting, except for only half the year, and Hans gets the same interest rate for the other half-year. You and Hans make your deal, and now Hans holds my bond. This matters not a whit to me, because I wasn't going to try and hunt you down to pay you back in a year; you would've come to me, my bond in hand, and asked for your money back. Now, instead of you, Hans will come to me at the end of the year and get the $1000.
Now let's add one complication. What would happen if, when you and Hans were negotiating to sell my bond, Hans'd had other options? What if a fourth person, call her Martha, had been also offering to sell a six-month bond of her own? She only wants to borrow $1000 for six months. She's offering her bond for sale for only $992. Remember that you are trying to sell my bond for $995. What luck do you expect to have selling my (virtually) identical bond for more money? You're going to have to sell my bond for $992 if you want any hope of selling it. Remember that we said that the price that a bond sells for when it it "new," that is, when it is sold by its original borrower, determines the interest rate. The $1000 bond I sold you for $990 had an interest rate of 1%. So what is the interest rate on Martha's bond? (1000-992)/992 = 0.8%, but since this bond is only for six months instead of a year, the effective interest rate is twice that, or 1.6%. So what has happened here is that the prevailing interest rate has gone up from 1%, when I sold you my bond, to 1.6%, when Martha is offering to sell her bond. What has this done to my bond (your asset)? It has decreased its value. You can't sell it for the $995 that you'd want to in order to get the rate of return that you'd anticipated. You have to sell it for $992, which means that you only earned 0.4%. Now, if you hold your bond until its "maturity," that is, until the time that I agreed to pay you back, you would get the money we agreed to, unless I went bankrupt. But once you start buying and selling "used" bonds, that is, bonds whose original buyers wish to sell them, you face the same risk you face with assets like stocks and gold.
This is how the selling price of ("used") bonds moves in the opposite direction as the current interest rate. I hope this helps. If I've just made a pig's breakfast of the whole thing, let me know below.
(*Note: Math is simplified for explanatory purposes. Real interest rate calculations are slightly more involved.)
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