Question

What is the logic of the interest rates and bonds being inversely proprtional (if interest rate goes up, bond price goes down)?

I know that PV = FV/(1+interest)^year ; since interest rate is in the demoninator, as the interest rate goes up, the bond price goes down, which makes sense mathematially.

But logically, if the interest rate goes up (you get a higher return every 6 months), shouldn't the bond price go up, because there is more demand for this asset that is returning more money every 6 months?

Answer 1

As I understand you mathematical understanding is clear on formula.

Let’s see the concept of: if interest rate goes up, bond price goes down.

Bond coupons which we get is fixed say 10% on $1000 for maturing in 5-years. So, we will receive $ 100 every year till maturity and this payment is not going to rise or fall because it is a contract both issuer and investor agrees as per clause of the bond.

Now, whatever be interest rate in the market be 15% or 16% or 20% the bond holder will only receive $100 for all the years. If this bond carries 10% interest coupon and New bond issuers in market is paying (say) 20% then why the investors will buy this bond? They will choose new bond in market.

Now, bond holder of 10% coupon will start selling its bonds cheap to match the interest of market. If bond holder will not sell cheap then there will be no demand for 10% rate bond when market is giving 20%.