Question

Explain why there is an inverse relationship between the price of bonds and the interest rate, or yield, on bonds. (Remember that simply stating there is an inverse relationship is not the same as explaining why the relationship is inverse). It might be best to use an example here.

Answer 1

If interest rates increase, the prices of debt securities such as debentures and bonds decrease because of opportunity cost of investments.

Debt securities are issued at a fixed coupon rate which is payable at fixed time interval, hence when interest rates increase, debt securities issued at older rates provide returns at lower rates as compared to revised higher interest rates.

Example: A bond is paying annual coupon at 7% p.a, now general interest rates rise in economy and therefore a bank fixed deposit is pay 9.5% p.a. In this case a rational investor will divert his investment from bonds to fixed deposits.