What’s the relationship between bond prices & the market interest rate? What’s the logic behind this relationship?

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What’s the relationship between bond prices & the market interest rate? What’s the logic behind this relationship?

In: Economics

Bonds are a commitment for a party to pay a set amount in the future. The value of that future payment today is dependent on the current interest rate.

For example, if somebody promises to pay me $105 one year from now and the prevailing interest rate is 5% then it is worth it for me to buy the right to receive that payment for $100 (I’m ignoring any risk premium for simplicity).

Based on standard net present value calculations the higher the interest rate the lower the current price of the future payment and vice versa. Prices and interest rates are inversely related.

Bond prices and interest rates move in opposite directions.

When interest rates rise, you have to discount a bond’s price to get the effective interest rate in line with prevailing interest rates. You have a bond that pays 5% interest, but rates rise to 6%. Why would anybody be willing to buy your bond that pays 1% less interest? But if you give a discount so that their effective rate becomes 6% then somebody will buy it.

Conversely, when rates fall bond prices will go up since people are willing to pay the premium due to the higher rate. If you’re getting 5% and rates fall to 4% you wouldn’t have any incentive to sell unless they offer a premium lowering the effective rate to about 4%.