Why Do Bond Prices Move Inversely To Interest Rates?

Understanding the inverse relationship between bond prices and interest rates is fundamental for investors navigating the fixed-income market. This relationship, known as the interest rate risk, is crucial for bond investors to comprehend as it impacts bond prices and investment returns. Let's delve into the reasons behind why bond prices move inversely to interest rates:
Bonds pay fixed coupon rates, which represent the annual interest payments as a percentage of the bond's face value. When market interest rates rise above the coupon rate, newly issued bonds offer higher yields, making existing bonds with lower coupon rates less attractive. As a result, the prices of existing bonds fall to align with the prevailing market yields.
Bond prices adjust inversely to changes in market interest rates to maintain the yield-to-maturity (YTM) in line with the prevailing market yields. When interest rates rise, bond prices fall to increase the YTM for investors purchasing the bond at a discounted price. Conversely, when interest rates decline, bond prices rise to decrease the YTM for investors purchasing the bond at a premium.
Duration is a key measure of a bond's sensitivity to changes in interest rates. It represents the weighted average time it takes to receive the bond's cash flows, including coupon payments and the return of principal. Bonds with longer durations exhibit higher interest rate sensitivity, and their prices tend to fluctuate more significantly in response to interest rate changes.
Macaulay duration measures the weighted average time to receive the bond's cash flows, while modified duration measures the percentage change in a bond's price for a given change in yield. Both measures help investors assess interest rate risk and make informed investment decisions.
Bond prices also reflect investors' expectations about future interest rate movements and economic conditions. If investors anticipate rising interest rates due to improving economic conditions or central bank policy actions, they may sell bonds, driving prices lower.
During periods of economic uncertainty or market volatility, investors may seek safety in bonds, particularly government bonds, pushing bond prices higher and yields lower, irrespective of prevailing interest rates.
Falling interest rates expose investors to reinvestment risk, where they may have to reinvest coupon payments or the return of principal at lower rates in the future. This can impact the overall yield and total return of the bond investment.
Bond investors consider both current income and potential capital gains or losses when evaluating bond investments. Changes in interest rates affect both the current income stream from coupon payments and the future capital gains or losses upon bond maturity or sale.