What is the relationship between interest rates and bond prices?

Understanding the inverse relationship between bond prices and interest rates is fundamental to bond investing. Here's an explanation of how this relationship works:

1. Bond Prices and Yield: Bond prices and bond yields (interest rates) have an inverse relationship. When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise.

2. Fixed Coupon Rate: Bonds typically pay a fixed coupon rate to investors. This means that when you purchase a bond, you lock in a fixed interest rate for the life of the bond.

3. Par Value: Bonds also have a face value or par value, which is the amount the bond will be worth when it matures. For example, a $1,000 par value bond will be worth $1,000 at maturity.

4. Current Yield: The current yield of a bond is calculated by dividing the annual interest payment (coupon) by the current market price of the bond. This yield can fluctuate based on changes in the bond's market price.

5. Bond Prices and Market Conditions: Bond prices can fluctuate in the secondary market based on changes in market conditions, including changes in interest rates.

Here's how the inverse relationship between bond prices and interest rates plays out:

a. Rising Interest Rates:

• When market interest rates rise, newly issued bonds offer higher coupon rates to investors to remain competitive. These higher coupon rates make existing bonds with lower coupon rates less attractive to investors.
• As a result, the market price of existing bonds with lower coupon rates falls to bring their yields in line with the higher prevailing interest rates. Investors are willing to pay less for these bonds because they offer lower yields compared to new bonds.
• This price drop can result in capital losses for investors who hold existing bonds, particularly if they sell the bonds before maturity.

b. Falling Interest Rates:

• Conversely, when market interest rates fall, newly issued bonds offer lower coupon rates because there is less need to attract investors with high yields.
• Existing bonds with higher coupon rates become more attractive to investors because they offer higher yields compared to new bonds with lower coupon rates.
• As a result, the market price of existing bonds with higher coupon rates rises as investors are willing to pay a premium for these bonds.
• This price increase can result in capital gains for investors who hold existing bonds, and they may be able to sell these bonds at a premium.

c. Bond Maturity and Par Value:

• It's important to note that if an investor holds a bond until maturity, they will receive the bond's par value, regardless of market price fluctuations during the bond's term.
• This means that bond investors who hold until maturity can avoid the impact of changing interest rates on the market price.

In summary, the inverse relationship between bond prices and interest rates means that when interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. Investors in bonds need to consider these price fluctuations, especially if they plan to sell their bonds before maturity. Holding bonds until maturity can help investors avoid the impact of changing market prices and ensure they receive the bond's par value at maturity.