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I know the relationship between price and yield for a simple coupon bond. When the rates go down price goes up. However, when rates go down, I assume bonds are less attractive and as a result the demand for them falls. As demand falls I expect prices to go down as less buyers want them. Aren't there 2 forces pulling prices in different directions then? Please help me understand which force is more important then in this scenario of falling yields for bonds.

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    If rates go down, your fixed rate bond, issued before rates declined has a higher coupon. Therefore, demand goes up, until the ytm matches the general market (it declined sufficiently).
    – AKdemy
    Dec 20, 2023 at 0:49

2 Answers 2

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Interest rate changes do not affect the yield of bonds already sold. If the interest rate goes down, bonds with the older interest rates only increase in value because there will always be higher demand for a higher yielding bond than a lower yielding one. E.X. You buy a $100 bond with a 1% interest rate

Interest rates fall to 0.5%

Now, to receive the same amount of interest as the bond you currently have, you would need to buy $200 worth of the new bonds.

So the bond you bought would now also be worth $200. Any price under 200 on your bond would be a more preferrable price than buying from the government.

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    "So the bond you bought would now also be worth $200." No, not really. It would be worth whatever the current interest rate says about getting $100 at the bond's end date. Consider your example: as you say, interest rates fall to 0.5%. Let's consider the bond has a remaining time of 1 year. A newly issued bond will give you $5 after one year, additionally to the $100 of principal. Your bond will give you $10 after this year, so you will be able to sell it for (about) $5 more, thus for $105. The buyer will get $100 plus $10 for his $105 → about the same yield as a newly issued bond for $100.
    – glglgl
    Dec 20, 2023 at 12:54
  • While you have the general premise correct (bonds values go down as interest rates go up), the bond would not nearly double in price when the rate is cut in half. Most of the bond value is based on the value at redemption.
    – D Stanley
    Dec 20, 2023 at 22:10
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Yields are the driving forces, supply and demand will instantly adjust in the market to match any change on yield. The new perceived yield drives the dynamics of supply and demand. Yield is the magnet.

This is very simplified because there are 10 different types of risks that need to be taken into account to pricing bonds.

The bond market is approximately a $50T market. It is extremely efficient in pricing and re-pricing. If there are any inconsistencies, they will be "ARB*" away almost instantly.

*arb: Arbitrage; If an institution holds ABC "AA" bonds that yield 5.25% while its comparable trade at 5.35%, trading desks around the world will dump the 5.25 (everything else equal) until it reaches 5.35 to buy the 5.35 for the same level of risk (AA).

We might say but what about the newly bought 5.35 will the yield drop because of all the new buys. Maybe but guess what will happen? Sellers will step in.

The bond market is in permanent flow toward a perceived point of equilibrium at any moment in time.

But in your question I see a point I haven't addressed here which is the appeal to hold bonds in a falling rate environment.

  1. It can be very profitable to buy bonds at/near the peak of the cycle just before a recession, for example, not only do you receive the coupon, but, you also get capital appreciation if you wanted to sell before maturity and switch to stocks for example. The real competition to bonds is equities. So in a sense yes, the lower rates are, the more money will flow to stocks. But as you have also seen from the last 20 years, lower yield did NOT translate into higher supply to create falling prices. Because yields rule and prices will gravitate around the perceived yield curve.

All assets compete with each other. If you don't like your bond at 3% because you know NVDA will triple ;-) while fed fund rates are at 0.5, somebody will buy it from you because 3 is better than 0.5. A lot of institutions and corporations have mandates to hold term paper over equities. Demand is always there and they all trade based on the yield curve, whether rates are falling or rising.

Hope this helps

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