What effect does an increase in interest rates or inflation have on bond prices?

What effect does an increase in interest rates or inflation have on bond prices?

• A. Bond prices increase
• B. Bond prices decrease
• C. Bond prices remain unchanged
• D. Bond prices fluctuate randomly

Answer: (B)

When interest rates or inflation rise, bond prices typically decrease. This relationship stems from the way bonds operate in the marketplace. Bonds pay a fixed interest rate, known as the coupon rate, which means that when new bonds are issued at higher interest rates, existing bonds with lower rates become less attractive to investors. As new investors seek those higher returns from newly issued bonds, the older bonds must adjust their prices downward to compete in the market. This allows investors to sell their older bonds at a price that reflects the current higher interest environment. Furthermore, inflation erodes the purchasing power of future cash flows from bonds, making them less appealing as well; thus, increasing inflation tends to drive down bond prices even further. This fundamental principle is crucial for understanding bond market dynamics and the overall impact of economic factors on fixed-income securities.

When interest rates or inflation rise, bond prices typically decrease. This relationship stems from the way bonds operate in the marketplace. Bonds pay a fixed interest rate, known as the coupon rate, which means that when new bonds are issued at higher interest rates, existing bonds with lower rates become less attractive to investors.

As new investors seek those higher returns from newly issued bonds, the older bonds must adjust their prices downward to compete in the market. This allows investors to sell their older bonds at a price that reflects the current higher interest environment. Furthermore, inflation erodes the purchasing power of future cash flows from bonds, making them less appealing as well; thus, increasing inflation tends to drive down bond prices even further.

This fundamental principle is crucial for understanding bond market dynamics and the overall impact of economic factors on fixed-income securities.