Bonds and Interest Rates
What is Bonds and Interest Rates?
Bond prices and interest rates move in opposite directions: when market interest rates rise, the price of existing bonds falls, and vice versa.
When interest rates rise, existing bonds with lower coupon rates become less attractive, causing their prices to fall. Conversely, when interest rates fall, bond prices rise. This inverse relationship is fundamental to understanding how monetary policy affects financial markets.
Bonds and Interest Rates: a worked example
A bond pays a fixed coupon of 30 dollars a year and has no maturity date, so its price is the coupon divided by the market rate. When comparable bonds yield 6 percent, this one sells for 30 / 0.06 = 500 dollars, because 30 dollars is exactly 6 percent of 500. Market rates then climb to 10 percent, so a freshly issued 500 dollar bond promises 50 dollars a year. Nobody will pay 500 dollars for a 30 dollar coupon anymore. The price falls until the yield matches: 30 / 0.10 = 300 dollars, a 200 dollar loss, or 40 percent, for whoever already held it. Run it the other way and the result reverses. If rates drop to 4 percent, the price rises to 30 / 0.04 = 750 dollars. The coupon never changed at any step. Only the price moved, and it moved opposite the interest rate every time.
The mistake students make with bonds and interest rates
The coupon rate and the yield get treated as one number, and they match at only one price. A bond issued at 500 dollars with a 30 dollar coupon carries a 6 percent coupon rate for life, but a buyer who picks it up later for 300 dollars is earning 30 / 300 = 10 percent. Asked for the return on a bond bought in the secondary market, students reach for the rate printed at issue. Divide the fixed coupon by the price actually paid, never by the face value or the original price.
Bonds and Interest Rates questions
Why do bond prices and interest rates move in opposite directions?
Bond prices fall when rates rise because the coupon payment is fixed. A bond paying 30 dollars a year is a 6 percent return at a price of 500 dollars, but if newly issued bonds offer 10 percent, buyers will pay only 300 dollars for that same 30 dollar stream. The price adjusts until the fixed payment delivers the going market yield. When rates fall instead, the old bond's above market coupon becomes attractive and its price gets bid up.
What happens to bond prices when the Fed buys bonds?
Bond prices rise. An open market purchase adds the central bank to the demand side of the bond market, bidding prices up, and a higher price on a fixed coupon means a lower yield. The same operation adds reserves to the banking system, expanding the money supply and pushing the nominal interest rate down in the money market. Both graphs tell one story: expansionary policy raises bond prices and lowers interest rates, while a bond sale does the reverse.
Does a bond issuer pay more when bond prices fall?
Bond issuers keep paying the same coupon. A firm that sold a bond promising 30 dollars a year owes 30 dollars a year whether the bond later trades at 500 dollars or at 300 dollars, so a price drop is a loss for the current holder rather than a cost to the issuer. Higher rates bite the issuer only on new borrowing, since a fresh bond now has to promise 50 dollars a year to sell for 500 dollars. That is the channel through which tighter monetary policy discourages investment spending.
This is the live Money Market sandbox. Drag the curves, or open the full version.
Related terms
Get AP Econ exam tips in your inbox
Occasional emails with study tips, new interactive graphs, and exam-season reminders. Free, no spam.
No spam. Unsubscribe anytime. Read our privacy policy.
Keep track of what you have studied
A free EconLearn account adds progress tracking, your quiz history, and achievements. Studying here is free either way, and there is nothing to pay for as a student.
Create a free accountAlready have one? Sign in
Last updated