How does an increase in interest rates affect bond prices?

An increase in interest rates typically leads to a decrease in bond prices. This relationship between interest rates and bond prices is a fundamental principle in fixed-income investing. When interest rates rise, newly issued bonds will generally offer higher yields compared to existing bonds, making those older bonds with lower yields less attractive to investors. As a result, the market value of existing bonds must decrease to adjust for their lower yields relative to the new bonds being issued. Consequently, investors looking to sell their older bonds will find that they can only do so at a lower price, thereby leading to a decline in bond prices.

This behavior is driven by the inverse relationship between bond yields and prices. As interest rates go up, the demand for existing bonds falls unless their prices adjust downward. Therefore, knowing this principle helps investors understand how bond markets react to changing interest rates, which is critical for making informed investment decisions.