What’s the relationship between bond prices & the market interest rate? What’s the logic behind this relationship?
In: Economics
Bond prices and interest rates move in opposite directions.
When interest rates rise, you have to discount a bond’s price to get the effective interest rate in line with prevailing interest rates. You have a bond that pays 5% interest, but rates rise to 6%. Why would anybody be willing to buy your bond that pays 1% less interest? But if you give a discount so that their effective rate becomes 6% then somebody will buy it.
Conversely, when rates fall bond prices will go up since people are willing to pay the premium due to the higher rate. If you’re getting 5% and rates fall to 4% you wouldn’t have any incentive to sell unless they offer a premium lowering the effective rate to about 4%.
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