Why does a bond's price decrease when interest rates increase?
Bond prices decrease when interest rates increase because the fixed interest and principal payments stated in the bond will become less attractive to investors.
Let's illustrate this with a $100,000 bond having a stated interest rate of 9% and having a remaining life of 5 years. This bond will pay $4,500 at the end of each of the 10 remaining semiannual periods plus $100,000 at the end of the bond's life. If an investor's goal is to earn 9%, the investor will pay $100,000 for the bond. However, if the market interest rates increase to 10% the investor will now be able to earn $5,000 semiannually on a $100,000 investment. Obviously, the 9% bond paying only $4,500 semiannually will no longer be salable for $100,000.
For an investor to buy the 9% bond in a 10% market, the bond's price will have to drop to an amount that will yield a 10% return over the bond's remaining life. Using our example, the investor will earn 10% only if the 9% bond can be purchased for approximately $96,000. The cash return of $4,500 every six months for five years on the $96,000 investment plus the gain of $4,000 ($100,000 in 5 years versus the investment of $96,000) will result in the required return of 10%.
If market interest rates decrease, the value of a bond will increase since the bond's stated fixed interest payments will be greater than the amounts available in new bonds issued at current market interest rates. (However, be aware that a bond's call price can limit the amount of increase in market value.)