How can an increase in the interest rate make bonds more attractive and reduce their price?

The Demand for bonds


an increase in the interest rate makes bonds more attractive, so its leads people to hold more of their wealth in bonds, as opposed to money.


However, you also learned that an increase in the interest rate reduced the price of bonds.


How can an increase in the interest rate make bonds more attractive and reduce their price?|||Bond prices move inversely to interest rates. When interest rates go up, bond prices go down and when interest rates go down, bond prices go up. Remember, we鈥檙e talking about previously issued bonds trading on the open market.





The inverse relationship is easy to see with this simple illustration.





A bond is issued for $10,000 for five years with a 5% coupon or interest rate, paid every six months. Then interest rates rise to 6%.





If you want to sell this bond, who would buy it when it is paying 1% below market rates (5% vs. 6%)? You have to sweeten the deal so the buyer gets a market rate for the bond.





You can鈥檛 change the interest rate on the bond. That鈥檚 fixed at 5%. You can, however change the price you will take for the bond.





The annual payment of $500 ($10,000 x 5%) must equal a 6% payment. Doing the math, you discover that the face value of the bond must be discounted to $8,333 so that the $500 fixed payment equals a 6% yield on the buyer鈥檚 investment ($8,333 x 6% = $500).





If interest rates went down instead of up, you could then sell your bond at a premium over face value because the fixed interest rate would be higher than the market rate.





Now say you don't have any bonds, and the interest rate rises to 6%. If this is a high interest rate, it's a good idea for you to purchase a bond at this current interest rate because the interest rate may decrease in the future. Thus, bonds are more attractive than holding money when the interest rate is high.|||Opportunity cost explains why bonds are more attractive when interest rates increase. Higher interest rates mean that bonds have a higher yield compared to alternatives for investment. You would rather be locked into higher yields when possible.





In order for existing bonds to reflect the higher interest rates, their price would have to decrease so that the effective yield increases along with the interest rates. Otherwise, nobody would want to buy existing bonds with lower than market interest rates.