Question

What is the relationship between bond prices and interest rates? Give an intuitive explanation of why this relationship exists.

Answer 1

The market value of bonds falls when interest rates rise. If you have a bond with a 3% coupon and the cash rate increases from 3% to 4%, for example, the coupon rate on the bond will now seem less attractive to investors so they'll be willing to pay less. Long-term bond market prices may be more volatile than short-term bonds, as changes to the relative return rate would have a greater impact over a longer period of time.

However, a lower price would improve the current yield for prospect investors because if they are able to purchase the bond for a discount, their overall return will be greater.

If interest rates go down, the prices of bonds will increase. That's because more people are going to want to buy bonds already on the market because the coupon rate is going to be higher than on similar bonds about to be issued, which will be influenced by current interest rates. If, for example, you have a bond with a coupon rate of 3% and the cash rate falls from 3% to 2%, then you and other investors might want to hold onto the bond as the interest rate has improved on a relative basis.

A rise in demand will push the bond's market price higher and bondholders may be able to sell their bonds at a price higher than their $100 face value.