What is the relationship between bond prices and interest rates?

The relationship between bond prices and interest rates is fundamentally inverse. This means that when interest rates rise, the prices of existing bonds tend to fall. This occurs because new bonds are issued at higher interest rates, making them more attractive to investors. As a result, the existing bonds with lower coupon rates become less desirable, leading to a decrease in their market price.

For example, suppose an investor holds a bond that pays a fixed interest rate of 5%. If new bonds are issued that yield 6%, investors would prefer the newer bonds because they offer a better return. Consequently, the market price of the existing 5% bond would drop as sellers try to attract buyers in a competitive interest rate environment.

Understanding this inverse relationship is crucial for investors and financial professionals as it impacts investment strategies and decisions regarding bond investments.