Why does interest rate go up when bond price goes down?

Thank you very much!

  • Welcome. This question is already answered here. money.stackexchange.com/questions/5174/… – MrChrister Jul 26 '11 at 23:43
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    @MrChrister, That other question doesn't seem like an exact dupe since it asks about stock prices instead of interest rates. – JohnFx Jul 27 '11 at 0:22
  • Hey, is not that the other way around? At least that is what I read! – Victor123 Feb 7 '14 at 21:32

You have the cause and effect backwards, the interest rate is the driver, not the bond price.

The value of a bond goes down when interest rates rise, and the value of a bond goes up when interest rates fall. Note that this is only the value if you want to SELL a bond, if you intend to hold it to maturity the value is unchanged.

The reason for the change is basically an adjustment to compete with new issues at the current rate.

Lets say you have a 10,000 bond that is paying 5%. That means your yearly return on the bond is $500. Then lets say rates rise to 6%, and you want to sell the bond. You need to make your bond as attractive to buyers as a new issue, why would someone buy your bond when they could spend the same amount on a new issue and make $600 per year? Or to think of it another way, they could spend $8333.33 and get the same $500 return as your bond is yielding. So to be competitive with new issues, the selling price of your bond would have to be aprox $8333.33

On the other hand, if interest rates fall, then to get the same return, someone would have to invest $12500, making your bond worth more than it's face value.

Those numbers are simplified because they don't take into account the maturity date of the bond and the face value when the bond matures. The actual fluctuation is less than the above numbers, but I wanted to keep the math simple for the moment to get the concept across.

Bond funds face similar pressures.

The way to avoid this is to buy and hold bonds to their maturity, when they are paid off at face value. The gain or loss in value does not affect you if you do not sell the bond before maturity.

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  • Either can cause the other. Interest rates encapsulate how much one will receive tomorrow for a dollar today; bond prices say how much one must pay today to receive a dollar tomorrow. – supercat Nov 24 '15 at 23:52

I think it's the other way around - the bond prices go down when the interest rates go up. If the bond interest rate is lower than the market - it is less attractive to the buyers.

Investopedia has an article on how the bond prices are made.

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User Chuck van der Linden's foregoing answer resembles http://www.investopedia.com/ask/answers/04/031904.asp, which I pruned it to simplify it even more:

Question: Why do interest rates tend to have an inverse relationship with bond prices?

Answer: At first glance, the inverse relationship between interest rates and bond prices seems ... illogical, but upon closer examination, it makes sense. An easy way to grasp why bond prices move opposite to interest rates is to consider zero-coupon bonds, which don't pay coupons, but derive their value from the difference between the purchase price and the par value paid at maturity.

For instance, if a zero-coupon bond is trading at $950 and has a par value of $1,000 (paid at maturity in one year), the bond's rate of return at the present time is approximately 5.26% ((1000-950) / 950 = 5.26%).

For a person to pay $950 for this bond, he or she must be happy with receiving a 5.26% return. But his/her satisfaction with this return depends on what else is happening in the bond market. Bond investors, like all investors, typically try to get the best return possible. If current interest rates were to rise, giving newly issued bonds a yield of 10%, then the zero-coupon bond yielding 5.26% would not only be less attractive, it wouldn't be demanded at all. Who wants a 5.26% yield when they can get 10%? To attract demand, the price of the pre-existing zero-coupon bond must decrease enough to match the same return yielded by prevailing interest rates. In this instance, the bond's price would drop from $950 (which gives a 5.26% yield) to $909 (which gives a 10% yield).

... [The same reasoning shows] why a bond's price would increase if prevailing interest rates were to drop. If rates dropped to 3%, our zero-coupon bond - with its yield of 5.26% - would suddenly look very attractive. More people would buy the bond, which would push the price up until the bond's yield matched the prevailing 3% rate. In this instance, the price of the bond would increase to approximately $970. Given this increase in price, you can see why bond-holders (the investors selling their bonds) benefit from a decrease in prevailing interest rates.

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