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Bonds are financial instruments that allow the seller of the bonds to to borrow funds from the buyer; in return, the bond issuer promises to repay the buyer the amount borrowed after a certain period of time and an additional amount that is known as interest. The interest rate of bonds is fixed when they are issued. Bonds, like other financial instruments are traded between investors, this creates the the bond market.
To illustrate how a rise in interest rates affects the value of bonds, consider the following case. A bond B with face value $1000 is issued when the prevailing interest rate was 7%. If the bond is bought at $1000 the buyer is assured a yield of 7% on the investment made. Assume interest rates rise after B was issued and now stand at 10%. A person that buys a bond now is assured a yield of 10% on the investment. If someone that had purchased bond B now wants to sell it in the bond market, the value at which B can be sold has to be less than $1000 in order to assure a yield of 10% for the buyer. The interest received from B is equal to 0.07*1000 = $70, if the yield has to equal 10%, the cost of the bond has to decrease to a value X such that 70/X = 0.1 or X = $700.
A rise in interest rates leads to a fall in bond prices in the bond market.
Thank you! If you would not mind a follow up question? Would this drop in the bond prices increase the demand for bonds? I would think following the law of supply and demand it would, but I thought the bonds market or loanable funds market didnt act the same.
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