Question

What happens to the price of an existing bond (in the secondary markets, which are typically over-the-counter) when interest rates rise across all maturity lengths?

Answer 1

Bond prices fluctuate in the secondary market just like any other security. The main cause of changes in bond prices is changing interest rates. When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. However, how much bond prices changes with interest rates depends primarily on 3 factors: maturity, yield, and the credit rating of the issuer.Bond prices and interest rates are inversely related, when interest rates fall bond prices rise and vice versa.

The larger the length of the bond’s remaining term, the more sensitive it will be to changes in interest rates. Hence a 1-year bond will change less than a 10-year bond or a 30-year bond, but it will have the same sensitivity to interest rates as a 30-year bond with 1 year to go until maturity and therefore bonds with longer remaining terms will be more volatile than those with less time until maturity.

This is because the present value of the interest payments and of the principal fall as interest rates rise and the present value increases when interest rates decrease. Similarly for the length of time remaining until maturity—the greater the bond's term, the lesser will be the present value of the bond's payments. The present value of any future payment is inversely proportional to length of time and to interest rates. Thus a rise in interest rates will cause the prices of bonds with long remaining terms to go down more than those with shorter remaining terms. Simultaneously if interest rates drop, then the present value of each payment increases proportionately.