What happens to the market price of each bond if the interest rates in the economy go up? Elaborate on your rationale.
The correct answer and explanation is:
When interest rates in the economy rise, the market price of bonds generally falls. This is because bonds and interest rates have an inverse relationship.
Here’s why: Bonds have a fixed interest payment, also called the coupon rate. When you purchase a bond, you are essentially agreeing to receive periodic interest payments based on the bond’s face value. The price of a bond is determined by the present value of these future interest payments and the face value that will be paid back at maturity.
When interest rates rise, new bonds are issued with higher coupon rates that reflect the current higher interest rate environment. As a result, the older bonds with lower coupon rates become less attractive to investors because they pay a lower return compared to the new bonds. To compensate for this, the market price of the older bonds must decrease so that their yield (the effective return an investor gets) aligns more closely with the current higher rates.
For example, if an investor can buy a new bond that pays 5% interest and a current bond with a 3% coupon, the older bond becomes less desirable unless its price drops. This drop in price increases the bond’s yield, making it more competitive with the new bonds offering higher interest payments.
Conversely, if interest rates fall, the market price of existing bonds with higher coupon rates rises, as they offer more attractive returns compared to newly issued bonds with lower rates.
This price adjustment process ensures that bonds in the market always reflect the prevailing interest rates, providing a balanced opportunity for both buyers and sellers. Thus, bond prices are sensitive to interest rate changes and will fluctuate accordingly.