Bond prices generally move in the opposite direction of interest rates. Why? Because coupon (interest) rates on newly issued bonds tend to reflect prevailing interest rates.

The two examples that follow illustrate how the market prices of existing bonds change in order to bring their yields in line with yields on newly issued bonds. This is a simplified approach and does not take into account the maturities and ratings of the bonds, both of which also influence price changes.

Suppose you bought a bond for $1,000 with a 6 percent coupon rate. You will receive $60 for each year that you hold that bond until it matures (at which time the issuer repays the $1,000 "face value"). But what if a year after you bought the bond, interest rates have risen so that bonds of similar quality and maturity to the one you own are issued with a 7 percent coupon rate (paying $70 a year in interest for each $1,000 invested)?

If you then wished to sell your 6 percent bond, you would have trouble finding a buyer willing to pay $1,000 for it. That's because for the same $1,000, the buyer could obtain a bond with a 7 percent coupon rate, providing an additional annual return of $10.

How can the bond with the lower coupon rate be made more attractive? Lower the price so that the dollar return to the investor ($60) will be equivalent to the going percentage return in the market (7 percent). If you, the seller, lowered the asking price of the bond to $857.14, the 6 percent coupon rate would result in an effective yield of 7 percent ($60 ÷ $857.14 = 7 percent). This process by which the face value of the bond decreases is known as discounting.

If instead of rising, interest rates were to fall from 6 percent to 5 percent, your 6 percent bond would increase in value to investors. They would be willing to offer you a premium for it. They would likely pay as much as $1,200 for your bond, because an annual return of $60 on a bond at that price results in an effective yield of 5 percent.

The articles and opinions in this publication are for general information only and are not intended to provide specific advice or recommendations for any individual. Consult your attorney, accountant, or financial or tax advisor with regard to your individual situation.

Mutual of America Life Insurance Company is a Registered Broker-Dealer.