Course → Unit 4: Bonds & Fixed Income → Lesson 4.2

Bond Prices and Yields

Bonds are sold as the "safe" part of a portfolio, but their prices move every single day in financial markets — and the single biggest reason why is something you'll now use to understand every interest-rate headline you ever read again.

The inverse relationship: yields up, prices down

Once a bond has been issued, it doesn't just sit still until maturity — it can be bought and sold in the market, just like a stock, and its price moves. The single most important rule to memorise in fixed income is this: when yields in the market rise, the price of existing bonds falls, and when yields fall, existing bond prices rise. This is called the inverse relationship between bond prices and yields, and it holds essentially all the time, for every bond, everywhere.

Why this happens — the intuitive version

Imagine you bought a newly issued bond last year for $1,000, with a 3% coupon. It pays you $30 a year. Now imagine that this year, new bonds of the same type and risk are being issued with a 5% coupon, because interest rates in the economy have risen. A new buyer can get a fresh bond paying $50 a year for the same $1,000. Why would anyone pay you $1,000 for your old bond that only pays $30, when they could get $50 elsewhere for the same price?

They wouldn't — unless you lower your price. To make your old 3% bond competitive with the new 5% bonds, you have to sell it for less than $1,000, so that the fixed $30 payment works out to a 5%-ish return for whoever buys it at the discounted price. That's the entire mechanism: a bond's coupon payment is locked in and can't change, so the only thing that can adjust when market interest rates move is the price people are willing to pay for that fixed payment.

The reverse is just as true. If market rates fall to 1%, your old 3% bond suddenly looks generous, and other investors will bid its price up above $1,000 to get their hands on it.

Duration: why long-dated bonds swing more

Not all bonds react to the same rate change by the same amount. A bond maturing in 1 year and a bond maturing in 30 years, both affected by the same 1% rise in rates, will not move in price by the same percentage — the 30-year bond will fall much further. The measure of this sensitivity is called duration — roughly, how many years' worth of future cash flows are "locked in" at the old, now-unattractive rate, weighted by how far away each payment is.

The intuition is simple: if your bond matures next year, you're only stuck receiving the below-market coupon for one more year before you get your money back and can reinvest it at the new, higher rate — the pain is small and short-lived. If your bond matures in 30 years, you're stuck holding a below-market payment for three decades, so the price has to fall much further today to make that investment fair to a new buyer. Longer maturity generally means higher duration, which means greater price sensitivity to interest rate changes — in either direction.

Credit rating: AAA to junk

The inverse relationship explains how market-wide rate changes move prices, but there's a second factor that determines how high a bond's yield is in the first place: how likely the issuer is to actually pay you back. Independent agencies — Moody's, S&P, and Fitch are the big three — assess this risk and assign a credit rating, a letter grade summarising the issuer's ability to meet its debt obligations.

The pattern here is simply risk and reward again: a shakier borrower has to offer a juicier interest rate to convince anyone to lend to it, exactly the same logic as a bank charging a riskier customer a higher loan rate. A downgrade in a bond's credit rating — meaning the rating agency now sees more default risk than before — will push its price down and its yield up, independent of anything happening to interest rates in the wider economy.