Bond Price, Yield and Interest-Rate Relationship - Article

Introduction

Understanding the relationship between bond price, yield, and interest rates is one of the most important foundations of treasury management.

A bank treasury may hold:

• Central Government securities;

• State Government Securities;

• corporate bonds;

• debentures; and

• other fixed-income instruments.

Even when the issuer continues to pay the promised coupon, the market value of the bond can change every day.

The basic reason is simple:

Investors compare the return from an existing bond with the return currently available in the market.

If market interest rates rise, an older bond paying a lower coupon becomes less attractive. Its price must fall to offer a competitive return.

If market interest rates fall, an older bond paying a relatively high coupon becomes more attractive. Its price rises.

Therefore:

Market Yield ↑ → Bond Price ↓

Market Yield ↓ → Bond Price ↑

RBI describes this as the fundamental inverse relationship between bond prices and market yields.

The current 2026 IIBF CAIIB BFM syllabus includes Securities Market Products under Module C – Treasury Products, while bond pricing, yield and interest-rate risk are important concepts across treasury and risk management.

Learning Objectives

After studying this topic, you should be able to:

• explain why bond prices change when market interest rates change;

• distinguish coupon rate, current yield, and Yield to Maturity;

• understand par, premium, and discount bonds;

• explain why maturity and coupon affect price sensitivity;

• understand how treasury can make gains or losses from interest-rate movements;

• distinguish credit risk from interest-rate risk; and

• identify common CAIIB traps involving price and yield.

Basic Structure of a Bond

A conventional fixed-rate bond has three important features.

Face Value

Face value, or par value, is the principal amount that the issuer agrees to repay at maturity.

For Government securities, market quotations are commonly expressed with reference to ₹100 face value.

Coupon

The coupon is the contractual interest paid on the face value.

If a bond has:

• face value = ₹100; and

• coupon rate = 7%,

the annual coupon amount is ₹7, irrespective of whether the bond later trades at ₹95, ₹100, or ₹105.

Maturity

Maturity is the date on which the principal is due for repayment.

These contractual cash flows may remain unchanged, but their present market value changes when market yields change.

Coupon Rate Is Not Market Yield

This distinction is essential.

Suppose a Government bond was issued with a 7% coupon.

Later, market interest rates rise to around 8%.

The bond does not automatically start paying an 8% coupon.

Its coupon remains 7%.

Instead, the bond's market price falls, allowing a new investor buying it at the lower price to earn a higher effective return.

Similarly, if market yields fall below 7%, the same 7% coupon becomes attractive and investors may be willing to pay more than face value.

Therefore:

Coupon changes only according to the bond contract.

Yield changes according to market price and market conditions.

Why Bond Price and Yield Move in Opposite Directions

Assume two bonds are otherwise comparable.

Existing Bond

Pays a fixed coupon based on the rate prevailing when it was issued.

New Market Bond

Offers a return reflecting today's higher market interest rate.

If the old bond continues trading at ₹100 while offering a lower return, investors will prefer the new bond.

The old bond must therefore become cheaper.

At a lower purchase price, its fixed future cash flows provide a higher return to the new buyer.

This restores market competitiveness.

The opposite occurs when market rates fall.

Bond Trading at Par

A bond is said to trade at par when:

Market Price = Face Value

For example, a ₹100 face-value bond trading at ₹100 is at par.

When a conventional bond's coupon rate broadly equals the market-required yield for that bond, it tends to trade around par.

The exact market price can still reflect factors such as:

• accrued interest;

• liquidity;

• credit risk;

• settlement;

• demand and supply; and

• specific bond features.

Bond Trading at a Premium

A bond trades at a premium when:

Market Price > Face Value

Why would an investor pay more than ₹100 for something that ultimately repays ₹100?

Because the bond may be paying a coupon that is attractive relative to current market rates.

For a conventional fixed-rate bond:

Coupon Rate > Required Market Yield → Bond tends to trade above par

The investor pays a premium to obtain the relatively attractive coupon stream.

Bond Trading at a Discount

A bond trades at a discount when:

Market Price < Face Value

This commonly occurs when the bond's coupon is lower than the return currently demanded by the market.

Therefore:

Coupon Rate < Required Market Yield → Bond tends to trade below par

The lower purchase price compensates the investor for receiving the relatively low coupon.

Par, Premium and Discount Relationship

This is one of the easiest ways to solve conceptual CAIIB questions.

Different Meanings of Yield

The word yield can refer to different measures.

For CAIIB, do not treat all yield measures as identical.

Coupon Yield

Coupon yield is based on the bond's annual coupon relative to face value.

For a fixed-rate bond, the coupon rate is established by the bond terms.

It does not change merely because the market price changes.

RBI similarly distinguishes coupon yield from market-based yield measures.

Current Yield

Current yield compares the annual coupon income with the bond's current market price.

Therefore, when the market price changes, current yield also changes.

Suppose the coupon payment remains unchanged.

Then:

Price falls → Current yield rises

Price rises → Current yield falls

However, current yield is incomplete because it considers coupon income but does not fully consider:

• gain or loss between purchase price and maturity value;

• timing of all future cash flows; or

• reinvestment of coupon payments.

Yield to Maturity

Yield to Maturity, or YTM, is the expected rate of return on a bond if it is purchased at the current price and held until maturity, assuming the contractual payments are received and the YTM assumptions are satisfied.

Conceptually, YTM considers:

• current purchase price;

• future coupon payments;

• maturity value; and

• remaining time to maturity.

RBI describes YTM as the discount rate at which the present value of the bond's future payments equals its current price.

For CAIIB, YTM is generally a much more complete measure of bond return than coupon rate or current yield.

Coupon Rate vs Current Yield vs YTM

This distinction is highly exam-relevant.

Effect of Rising Interest Rates

Suppose treasury holds a fixed-rate Government bond.

Market rates rise significantly.

New securities are now issued at higher yields.

The existing bond's coupon remains unchanged.

Therefore:

1. existing bond becomes relatively less attractive;

2. investors demand a lower purchase price;

3. its market price falls; and

4. its yield rises toward the new market level.

For a treasury marking the security to market, this can create a valuation loss.

This is interest-rate risk.

Effect of Falling Interest Rates

Now assume market yields decline.

The existing bond continues paying its higher contractual coupon.

The bond becomes more attractive.

Therefore:

1. demand for the existing bond increases;

2. its price rises;

3. its market yield falls; and

4. treasury may experience a valuation or trading gain.

RBI specifically notes that declining interest rates can create capital-gain opportunities in Government securities because of the inverse price-interest-rate relationship.

Price Change Does Not Alter Face Value

A bond's secondary-market price may move considerably without changing the contractual face value.

For example:

• face value may remain ₹100;

• market price may move from ₹100 to ₹96;

• maturity redemption may still be ₹100 according to the contractual terms.

Therefore, do not confuse:

market price with redemption value.

Interest-Rate Risk

Interest-rate risk is the risk that changes in market interest rates will adversely affect the value or earnings of an interest-sensitive position.

For a fixed-rate bond:

Rates rise → Bond price generally falls

This creates potential market loss if the security must be:

• sold;

• marked to market; or

• valued under the applicable accounting framework.

A bank can therefore suffer valuation losses even when the Government or corporate issuer has made every payment on time.

Credit Risk vs Interest-Rate Risk

This distinction is particularly important in treasury.

Government securities are often treated as free from conventional domestic credit/default risk, but their prices remain sensitive to market yields.

Why Some Bonds Move More Than Others

All fixed-rate bonds do not react equally to a given interest-rate change.

Two important factors are:

Time to Maturity

Generally:

Longer maturity → Greater price sensitivity

A long-term bond has cash flows extending further into the future.

Changes in the discount rate therefore have a larger effect on their present value.

A short-maturity bond is closer to repayment and normally shows lower price sensitivity.

Coupon Rate

Generally, for bonds with the same maturity and similar characteristics:

Lower coupon → Greater price sensitivity

A low-coupon bond receives a larger proportion of its total value later, especially through principal repayment.

A high-coupon bond returns more cash earlier through coupons.

Therefore, the low-coupon bond generally reacts more strongly to interest-rate changes.

Zero-Coupon Bond Sensitivity

A zero-coupon bond has no intermediate coupon payments.

All contractual value is received at maturity.

Therefore, for a given maturity, it generally has greater interest-rate sensitivity than a coupon-paying bond.

This principle later becomes important when studying duration.

Detailed duration treatment belongs to Treasury Risk Management, but at this stage remember:

Longer cash-flow timing generally means greater sensitivity to yield changes.

Price-Yield Relationship Is Curved

The relationship between price and yield is inverse, but it is not a perfectly straight line.

The price-yield relationship for a conventional bond is convex.

Conceptually:

• when yield falls by a given amount, the percentage price gain is generally slightly greater than

• the percentage price loss resulting from an equal rise in yield,

all else being equal.

Detailed convexity calculations are not required here, but the concept explains why a straight-line estimate of bond-price movement becomes less accurate for larger yield changes.

Role of Market Expectations

Bond prices respond not only after an interest-rate decision actually occurs.

Markets also react to expectations.

For example, if investors expect future monetary tightening, bond yields may rise before the policy rate is formally increased.

Similarly, expectations of:

• lower inflation;

• easier monetary conditions;

• weaker economic growth; or

• improved market liquidity

may push yields lower.

Therefore, treasury constantly monitors:

• monetary-policy expectations;

• inflation;

• Government borrowing;

• liquidity;

• global bond markets;

• foreign-exchange developments; and

• other macroeconomic factors.

RBI also identifies interest rates, inflation expectations, liquidity, other domestic financial markets, global bond-market developments, and policy actions among factors influencing Government-security prices.

Role of Liquidity and Demand

Not every price movement arises solely from expected policy rates.

Bond prices can also be affected by:

• market liquidity;

• demand from banks and institutional investors;

• supply from Government borrowing;

• foreign portfolio flows;

• security-specific liquidity; and

• risk sentiment.

Therefore, two bonds with similar maturities may not always trade at exactly the same yield.

The price-yield principle remains important, but actual market pricing can reflect several factors simultaneously.

Practical Banking Application

Assume a bank treasury holds a large portfolio of fixed-rate Government securities.

Scenario 1: Treasury Expects Interest Rates to Fall

If yields actually decline:

• existing fixed coupons become more attractive;

• bond prices generally rise; and

• treasury may earn valuation or trading gains.

Scenario 2: Treasury Expects Rates to Fall but Rates Rise

Now:

• new securities offer higher market yields;

• existing bonds become less attractive;

• bond prices fall; and

• treasury may suffer valuation losses.

Scenario 3: Treasury Needs Liquidity

Even if treasury originally intended to hold the bond to maturity, an unexpected liquidity requirement may force it to sell.

The prevailing market yield at the time of sale will influence the realised price.

This illustrates why interest-rate risk matters even for high-quality securities.

Holding to Maturity Does Not Mean Price Never Changes

Another conceptual trap is:

“If a bond will eventually redeem at face value, today's price movement does not matter.”

This is too simplistic.

Market-price movements can matter because:

• the bank may sell before maturity;

• applicable accounting may require valuation effects;

• collateral value may change;

• risk measures may change;

• liquidity requirements may force disposal; and

• opportunity cost changes when market yields move.

Therefore, treasury still monitors market value even when the issuer's contractual repayment is expected.

Pull to Par

As a conventional bond approaches maturity, assuming no default and stable conditions, its price generally moves toward its redemption value.

This is sometimes described as pull to par.

For example:

• a premium bond must eventually lose the premium as maturity approaches if redemption occurs at par;

• a discount bond must move toward par as maturity approaches, assuming other factors remain unchanged.

This is important because part of an investor's return can arise from the bond price moving toward face value.

Premium Bond and YTM

Suppose a bond trades above face value.

The investor receives:

• coupon income; but

• ultimately only the contractual redemption value.

Therefore, part of the premium paid is effectively lost as the bond moves toward redemption at par.

This helps explain why:

Premium bond → YTM below coupon rate, under normal plain-vanilla conditions.

Discount Bond and YTM

For a bond purchased below face value:

• the investor receives coupon income; and

• also benefits from movement toward the higher redemption value if held to maturity.

Therefore:

Discount bond → YTM above coupon rate, under normal conditions.

These relationships are highly useful in conceptual exam questions.

Treasury Decision-Making

Treasury should never evaluate a bond using only the coupon rate.

Consider two securities:

Bond A

• Coupon: 8%

• Price: substantial premium

• Shorter maturity

Bond B

• Coupon: 7%

• Price: discount

• Longer maturity

It would be wrong to conclude automatically that Bond A provides the better return merely because its coupon is higher.

Treasury should evaluate:

• market price;

• YTM;

• maturity;

• duration;

• liquidity;

• credit quality;

• expected interest-rate movement;

• reinvestment risk; and

• portfolio objectives.

CAIIB Exam Focus

Bond price and market yield move inversely.

This is the central concept.

Coupon rate does not change simply because market rates change.

A bond trading above face value is a premium bond.

A bond trading below face value is a discount bond.

For a normal fixed-rate bond:

Coupon > YTM → Premium

Coupon = YTM → Par

Coupon < YTM → Discount

Current yield and YTM are not the same.

Current yield considers coupon relative to market price, while YTM considers the broader set of cash flows up to maturity.

Longer-maturity bonds generally have greater interest-rate sensitivity.

Lower-coupon bonds generally have greater sensitivity than higher-coupon bonds of similar maturity.

A Government security can have very low credit risk and still suffer a market-price loss.

Price-yield relationship is inverse but not perfectly linear.

Market expectations can move bond yields before an actual policy decision occurs.

Higher coupon does not necessarily mean higher investment return.

Common Exam Traps

Trap 1: Interest Rates Rise, Therefore Existing Bond Prices Rise

Incorrect.

For a conventional fixed-rate bond:

Rates/Yields ↑ → Price ↓

Trap 2: Coupon Rate and YTM Are Always Equal

Incorrect.

They are normally equal only when a plain bond trades around par under standard assumptions.

Trap 3: A Bond with an 8% Coupon Always Gives an 8% Return

Incorrect.

The return depends on the purchase price and other cash-flow assumptions.

Trap 4: Premium Bond Has YTM Above Coupon Rate

Normally incorrect.

For a plain fixed-rate bond trading at a premium:

YTM < Coupon Rate

Trap 5: Discount Bond Has YTM Below Coupon Rate

Normally incorrect.

For a plain fixed-rate bond trading below par:

YTM > Coupon Rate

Trap 6: Government Securities Have No Interest-Rate Risk

Incorrect.

They can suffer significant valuation losses when market yields rise.

Trap 7: Long-Maturity and Short-Maturity Bonds React Equally to Rate Changes

Incorrect.

Longer-maturity bonds generally show greater price sensitivity.

Trap 8: Higher Coupon Always Means Greater Interest-Rate Risk

Incorrect.

For otherwise similar bonds, a lower-coupon bond generally has greater interest-rate sensitivity.

Trap 9: If a Bond Is Held to Maturity, Market Price Never Changes

Incorrect.

Its market price can change throughout its life even if the holder does not sell it.

Trap 10: A Bond Trading at ₹105 Will Be Redeemed at ₹105

Not necessarily.

Market price and contractual redemption value are separate concepts.

Trap 11: Current Yield Includes the Gain or Loss at Maturity

Incorrect.

Current yield mainly compares annual coupon income with current market price. YTM is the broader measure.

Trap 12: Price-Yield Relationship Is a Perfect Straight Line

Incorrect.

The relationship is generally convex.

Memory Technique

Remember:

Y UP → P DOWN

Y DOWN → P UP

For premium and discount bonds, remember:

C > Y → Premium

C < Y → Discount

where:

• C = Coupon Rate

• Y = Yield to Maturity

For interest-rate sensitivity, remember:

Longer + Lower Coupon = More Sensitive

These three relationships solve a large number of CAIIB conceptual questions on bonds.