Bond Prices and Interest Rates
The value of a bond is affected by several factors as it moves towards maturity. Chief among these are interest rates. As interest rates fluctuate, the present value of the bond and its future cash flows will change, which, in turn, affects its market price. The relationship is an inverse oneas rates rise, a bond’s price will drop, and vice-versa. Consider a bond that pays a 5% coupon when prevailing interest rates are 6%. An investor would not want to pay the full face value for that bond in the secondary market, since he or she could obtain a 6% coupon by purchasing a newly issued bond. Thus the price of the bond paying 5% would need to adjust downward to compensate for its below-market coupon rate.