Why do Bond Prices and Interest Rates have this Strange Relationship

It's a question that occurs to many who invest in bonds – why do bond prices and interest rates always move in opposite directions? They do have an inverse relationship, actually. When bond prices go up, their interest rates go down. And it works the other way, too. Why is this exactly?

It seems illogical to the novice at first that bond prices and interest rates would have an inverse relationship like this. You need to look a little closer to see how it makes sense. As a way to understand, try to consider how zero coupon bonds work.

Zero coupon bonds are valued on the difference in value that there is between the value paid at maturity and the purchase price. An example might make this easier to understand. Let's say that there is a zero coupon bond that trades at $900 when its par value is $1000. Then, you calculate the bond's right of return as 1000-900/900, or 11%.

Anyone paying $900 for this bond would need to be happy with a 11% return. They aren't supposed to simply look at this figure, though. They need to look at what else is on offer in the bond market really know if this rate of return is satisfactory.

Bond investors will always look for the best possible return like other investors. As current interest rates change and new bonds begin to get issued at 12% yield, the 11% from the bond of old will begin to look not that attractive anymore.

For the old zero coupon bonds to still be able to attract investors, they would have to be taken down and repriced to be able to match the kind of yield offered by the newly issued bonds. They might need in this case, to be repriced at perhaps $875, to compete.

This is how bond prices and interest rates move in opposite directions. When the interest rates move up, they have to reprice the bonds to be cheaper. What happens when the rates go down instead of up? If the rates were to drop to 10%, then our 11% bond would certainly look very attractive, indeed. Of course, the bond issuers would not want to lose out. So they would need to make their bonds dearer.

In general, investors like it when interest rates fall, and bond issuing institutions like it when they rise. That's the way these things work.