Inverse Relationship Between Bond Prices and Yields

An existing fixed-rate bond becomes less attractive when newly available bonds offer higher interest rates, so its market price falls. This inverse price-yield relationship arises because a bond’s promised cash payments remain fixed while investors’ required rate of return changes. It applies when other factors, such as credit risk, remain unchanged.

Fixed payments, changing market returns

A conventional fixed-rate bond promises periodic interest payments, called coupons, and repayment of its face value at maturity. Its coupon rate does not change merely because prevailing market interest rates change.

• When market rates rise, investors can obtain higher returns from comparable newly issued bonds. An existing bond with a lower coupon must therefore sell at a lower price to offer a competitive return.
• When market rates fall, the existing bond’s fixed payments become more attractive. Investors are willing to pay a higher price for them.
• This comparison concerns bonds with comparable maturity and credit risk, rather than every interest rate in the economy.

The present-value explanation

A bond’s price equals the present value of its expected future payments. Investors discount those payments using the market return required for a comparable investment.

• A higher required return means a higher discount rate, which reduces the present value of unchanged future payments.
• Suppose a bond has a face value of ₹100, pays a 5% annual coupon, and matures exactly one year from today. Its sole remaining payment is ₹105.
• If the required annual return is 5%, its price is ₹105 ÷ 1.05 = ₹100. If that return rises to 10%, its price falls to approximately ₹95.45.

Coupon rate is not the same as yield

The coupon rate measures annual coupon payments relative to face value. Yield to maturity is the discount rate that equates the bond’s current price with its remaining promised payments, assuming those payments occur as scheduled.

• A buyer’s return depends on the purchase price as well as the coupon and redemption payment. Therefore, an unchanged coupon does not imply an unchanged yield.

Connection with monetary policy

An increase in the policy rate can raise market yields and lower existing fixed-rate bond prices. However, yields also reflect expected future interest rates, inflation and risk, so different maturities need not move equally.

• Other things equal, bonds with higher duration experience larger percentage price changes for a small change in yield.