What is the relationship of bond prices to market interest rates?

The relationship between bond prices and market interest rates is fundamental to understanding fixed-income investments. When market interest rates rise, new bonds are issued with higher yields, making existing bonds with lower rates less attractive to investors. As a result, the prices of existing bonds decrease to adjust for the new, higher yields in the market.

This mechanism occurs because investors seek the best return on their investments, and if new bonds offer higher interest payments, they will not be willing to pay full price for existing bonds that pay lower interest rates. Thus, to sell those existing bonds in the face of new competition, sellers must lower the price, leading to a negative correlation between market interest rates and bond prices.

In contrast, when market interest rates fall, the prices of existing bonds increase, as their fixed interest payments become more attractive compared to new bonds issued at lower rates. This inverse relationship is a crucial concept in the bond market.