The Intricate Dance of Bonds and Interest Rates
The bond market, a crucial component of the global financial system, offers investors an opportunity to diversify their portfolios and mitigate risk. However, understanding the relationship between bond prices and interest rates can be a challenge for many. In this article, we will demystify this complex dynamic and explore why bond prices fall when interest rates rise, and vice versa.
I. The Basics of Bonds
Before we dive into the relationship between bond prices and interest rates, let’s briefly review the fundamentals of bonds. A bond is essentially a loan made by an investor to a borrower, typically a government or a corporation. The borrower issues a bond with a specific face value (also known as par value), interest rate (known as the coupon rate), and maturity date. The investor receives periodic interest payments throughout the life of the bond and gets the face value back when the bond matures.
II. The Inverse Relationship Between Bond Prices and Interest Rates
The relationship between bond prices and interest rates can be described as an inverse one. When interest rates increase, bond prices decrease, and when interest rates decrease, bond prices increase. This relationship can be attributed to a few key factors:
