Introduction

Bonds can provide investors with regular interest payments, but their market prices can change over time. One of the most important relationships in fixed-income investing is the connection between bond prices and yields.

Generally, when bond prices rise, their yields fall. When bond prices fall, their yields rise. This inverse relationship is primarily driven by changes in market interest rates and the fixed payments provided by existing bonds.

Understanding this relationship can help investors better evaluate bond investments and understand how changes in interest rates affect fixed-income markets.

1. What Is a Bond Price?

A bond price is the amount an investor would pay to purchase a bond in the market.

When a bond is first issued, it typically has a stated face value, such as $1,000. However, once it begins trading in the secondary market, its price can move above or below that amount.

Bond prices can change because of:

• Changes in market interest rates.
• Changes in the issuer's credit quality.
• Investor demand.
• Inflation expectations.
• Time remaining until maturity.

2. What Is Bond Yield?

Bond yield represents the return an investor may receive from a bond based on factors such as its price and interest payments.

For example, consider a $1,000 bond that pays $50 in annual interest. If the bond trades for $1,000, its current yield is 5%.

If the price falls to $900 while the annual interest payment remains $50, the current yield increases to approximately 5.56%.

This demonstrates why a bond's yield can change even when its coupon payment remains the same.

3. Why Do Bond Prices and Yields Move in Opposite Directions?

The inverse relationship exists because the bond's scheduled payments generally remain fixed.

Suppose an existing bond pays $50 in annual interest. If newly issued bonds begin offering higher interest rates, investors may be less willing to pay $1,000 for the older bond.

The older bond's price may therefore decline until its yield becomes more competitive with newly issued bonds.

The opposite can happen when market interest rates fall. Existing bonds with higher coupon payments can become more attractive, potentially causing their prices to rise and their yields to fall.

4. How Do Interest Rates Affect Bond Prices?

Interest rates are one of the most important factors affecting bond prices.

Generally:

• Interest rates rise → Bond prices fall → Bond yields rise
• Interest rates fall → Bond prices rise → Bond yields fall

The impact can be greater for bonds with longer maturities because their fixed payments extend further into the future.

This is known as interest rate risk, which is the possibility that changes in market interest rates will affect the value of a bond.

5. What Is the Difference Between Coupon Rate and Yield?

The coupon rate is the stated interest rate used to determine a bond's scheduled interest payments based on its face value.

The yield reflects the return associated with the bond's current market price and its expected payments.

For example, a bond with a $1,000 face value and a 5% coupon pays $50 in annual interest regardless of whether its market price is $900, $1,000, or $1,100.

However, its current yield changes as its market price changes.

This distinction is important because investors should not assume that a bond's coupon rate represents the return they will receive based solely on the price they pay.

Conclusion

Bond prices and yields generally move in opposite directions because the interest payments on existing bonds are typically fixed. When market interest rates rise, existing bonds can become less attractive, causing their prices to fall and their yields to rise. When rates decline, the opposite can occur.

Understanding this relationship is fundamental to fixed-income investing. By considering bond prices, yields, interest rates, maturity, and credit risk together, investors can better understand how changing market conditions may affect their bond investments.