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.)

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