How is bond working?
Bond is one way an agency borrows money from the public. Various ways for debtholder paying back money are available. For the sake of analysis simplicity, the coupon bonds as a typical way how the bond is working are picked for illustration. Coupon bonds are very straightforward: The bond issuers borrow capitals from lenders and promise to pay back the capital in a fixed interest rate for a specific period of time. e.g. the Government borrows 100$ from the public and promises to pay it back with 10$ per year (coupon price) through 10 years. On the ending of the 10th year, it will return the principle (100$) in addition.
How is the interest rate calculated:
the interest of a coupon bond (i) is determined by the present value formula. The formula is:
issuing price = coupon price / i + coupon price / i ^ 2 + …. coupon price / i ^ n + face value / i ^ n;
The example in “How is bond working” will be: 100 = 10/i + 10/i^2 + … 10/i^10 + 100/i^10 => i = ?
One observation:
The higher issuing price is, the lower the interest rate will be given coupon price & principle face value is fixed. Thus, the issuing price and interest rate are negatively related. The issuing price is decided by the supply and demand curve for the given bond (The high demand will raise the issuing price and high supply as opposed to demand will lower the issuing price)
As a conclusion:
Holding other factors constant, bond with a high interest-rate means a current low buying price. If the expected interest rate will be falling, the selling price will be higher before the bond mature date. One good example is the USA 30 years treasury bond experienced a big bull period from 1980 till now, the interest rate decreased from 15.5% to current 1.6%. The most difficult part then becomes how do we know the bond expected interest rate will rise or fall. In 1980, there was a big crisis in the debt market which caused panic through the debt market thus the high interest-rate for the 30-year treasury rate, it was like a gamble to make a decision buying or selling long term bonds then (nothing different from stock market). So, what’s your choice the next time?
https://www.macrotrends.net/2521/30-year-treasury-bond-rate-yield-chart