Question

What will happen to the interest rate of bond A if the liquidity of bond B increase?

Answer 1

Bonds have an inverse relationship to interest rates. When the cost of borrowing money rises, bond prices usually fall, and vice-versa.

At first glance, the negative correlation between interest rates and bond prices seems somewhat illogical. However, upon closer examination, it actually begins to make good sense.

• Most bonds pay a fixed interest rate that becomes more attractive if interest rates fall, driving up demand and the price of the bond.
• Conversely, if interest rates rise, investors will no longer prefer the lower fixed interest rate paid by a bond, resulting in a decline in its price.
• Zero-coupon bonds provide a clear example of how this mechanism works in practice.

An easy way to grasp why bond prices move in the opposite direction of interest rates is to consider zero-coupon bonds, which don't pay regular interest and instead derive all of their value from the difference between the purchase price and the par value paid at maturity.

Zero-coupon bonds are issued at a discount to par value, with their yields a function of the purchase price, the par value, and the time remaining until maturity. However, zero-coupon bonds also lock in the bond’s yield, which may be attractive to some investors.

If interest rates decline, bond prices will rise. That's because more people will want to buy bonds that are already on the market because the coupon rate will be higher than on similar bonds about to be issued, which will be influenced by current

If interest rates decline, bond prices will rise. That’s because more people will want to buy bonds that are already on the market because the coupon rate will be higher than on similar bonds about to be issued, which will be influenced by current interest rates.

If you have a bond with a coupon rate of 3% and the cash rate falls from 3% to 2%, for example, then you and other investors might wish to hold onto the bond as the rate of interest has improved on a relative basis.

A rise in demand will push the market price of the bonds higher and bondholders might be able to sell their bonds for a price higher than their face value of $100.

• Floating rate bondholders would lose out from a fall in interest rates because the coupon rises or falls in tandem with interest rates.