What is the relationship between bond prices and interest rates?

The relationship between bond prices and interest rates is inverse and fundamental in the world of fixedincome investing. When interest rates rise, bond prices typically fall, and when interest rates fall, bond prices generally rise. This inverse relationship can be explained through the concept of present value, and it has significant implications for bond investors. Here's how it works:

1. Present Value and Bond Prices:
The present value of future cash flows is a core financial concept. In the context of bonds, it means that the current price of a bond reflects the present value of its future cash flows, including both coupon payments and the repayment of the bond's face value at maturity.

2. Coupon Payments:
Bonds pay periodic interest payments, known as coupon payments, to bondholders. These payments are typically fixed and specified as a percentage of the bond's face value (par value).
When market interest rates rise above the bond's coupon rate, newly issued bonds offer higher yields than the older bonds with lower coupon rates. This makes the older bonds less attractive to investors in the secondary market because they provide lower income compared to newly issued bonds.

3. Discounting Future Cash Flows:
As interest rates increase, the present value of future cash flows from the bond decreases. This is because higher interest rates mean that future cash flows are worth less in today's dollars.
Bond prices in the secondary market adjust downward to reflect the lower present value of these future cash flows. In other words, the bond's price falls to make it more attractive to investors given the higher prevailing interest rates.

4. Inverse Relationship:
The relationship between bond prices and interest rates is inverse and linear. When interest rates rise by 1%, bond prices generally fall by approximately the bond's duration (modified duration) in percentage terms, assuming all other factors remain constant.
Conversely, when interest rates fall by 1%, bond prices generally rise by approximately the bond's duration in percentage terms.

5. Impact on Bond Types:
The effect of interest rate changes on bond prices can vary based on several factors, including the bond's time to maturity, coupon rate, and call provisions.
Longerterm bonds are more sensitive to interest rate changes than shorterterm bonds. Bonds with lower coupon rates are also more sensitive to interest rate fluctuations because they rely more on price appreciation to compete with newer, higheryielding bonds.

6. Yield to Maturity (YTM):
When a bond is purchased at a discount due to rising interest rates, its YTM increases. YTM reflects the total return an investor can expect to earn if the bond is held to maturity and all interest payments are reinvested at the YTM.
Conversely, when a bond is purchased at a premium (above its face value) due to falling interest rates, its YTM decreases.

In summary, bond prices and interest rates have an inverse relationship driven by the concept of present value. When market interest rates rise, bond prices tend to fall to bring the yield of existing bonds in line with newly issued bonds. Conversely, when interest rates fall, bond prices tend to rise. This relationship is a critical consideration for bond investors, as it affects the potential capital gains or losses associated with bond holdings and can impact overall portfolio performance.