How do changes in interest rates typically influence bond prices?

Changes in interest rates have an inverse relationship with bond prices, meaning that when interest rates rise, bond prices typically fall. This occurs because existing bonds, which were issued at lower interest rates, become less attractive compared to new bonds that offer higher yields. Investors would demand a discount on the older bonds to compensate for their lower yield, consequently pushing their prices down.

For example, suppose an investor holds a bond that pays a fixed interest rate of 4%. If prevailing market interest rates rise to 5%, new bonds will be issued at that higher rate. Consequently, the bond with the lower interest rate becomes less desirable and its market price decreases to align with the higher returns available in new issues.

Understanding this relationship helps to clarify the dynamics in the bond market and the impact of interest rate changes on investment strategies. This is critical for investors in managing risk and making informed decisions about bond investments.