How do interest rates impact bond prices?

The relationship between interest rates and bond prices is a fundamental concept in finance. When interest rates rise, the prices of existing bonds typically fall. This occurs because new bonds are issued with higher yields that reflect the increased interest rates, making existing bonds with lower yields less attractive to investors. Consequently, the demand for these existing bonds decreases, leading to a decline in their market price.

For instance, an investor holds a bond that pays 3% interest, and if market interest rates rise to 5%, new bonds will be issued at this higher rate. Investors looking for better returns will prefer these new bonds over the existing bond with a lower interest rate. As a result, the value of the existing bond drops in order to entice buyers, reflecting the higher interest rate environment.

Understanding this inverse relationship between interest rates and bond prices is crucial for investors as it informs their investment strategies based on market conditions.