A bond's price and its yield (interest rate) have what type of relationship?

Question

Accepted Answer

An inverse relationship  -  when interest rates rise, bond prices fall. Bond prices and yields (interest rates) have an inverse relationship. When market interest rates rise, existing bond prices fall, and when interest rates fall, existing bond prices rise. This occurs because when new bonds are issued at higher rates, existing bonds with lower coupon rates become less attractive, so their market price must decrease to offer a competitive yield to potential buyers.

The inverse relationship is a fundamental principle of fixed-income investing. A direct relationship (both moving in the same direction) does not describe how bond prices behave  -  it would mean that as new bonds offer higher yields, old bonds also increase in value, which makes no economic sense. Bond prices are influenced by credit ratings, but the interest rate-price relationship exists independently and is a mathematical certainty. The relationship is not random; it follows directly from the time value of money and is predictable and consistent.

For example, if you own a bond paying 3% interest and new bonds are issued at 5%, no one would pay full price for your 3% bond when they could buy a new one at 5%. Your bond's price must fall enough so that its yield to maturity equals the current market rate. The longer the bond's maturity, the more sensitive its price is to interest rate changes  -  this is called duration risk. Understanding the inverse relationship between bond prices and interest rates is crucial for the DSST Personal Finance exam because it affects investment portfolio values, particularly during periods of changing interest rates.

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