When the price of bonds shrinks or decreases, interest rates go up. Why is this?

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kipling2448 | (Level 3) Educator Emeritus

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Bonds and interest rates are said to have an "inverse relationship," meaning when one goes up, the other goes down. This, however, is a bit of an oversimplification. Bonds are issued at a fixed price, and have a predictable return based upon the face value of the bond. Interest rates, in contrast, fluctuate, often numerous times during the lifetime of a bond, depending upon the period of time before the bond in question matures. The value of bonds fluctuates with the interest rate, but, once a bond is issued, its value remains set. Consequently, the value of a bond relative to other investments can degrade or improve depending upon day-to-day interest rates. Those lower-value bonds may not have been exhausted, however. They might still exist in the marketplace. Should interest rates go up, those bonds still to be issued that mature at a lower rate than the newly-established interest rate would seem unattractive to investors, unless the purchase price of the bond decreased in direct proportion to the increase in the rate of interest. In other words, the institution marketing the bonds in question would offer them at a lower purchase price to compensate for the diminished value the bond would otherwise hold given the increase in interest rates. In that sense, there is an inverse relationship between the price of bonds and the rate of interest.