Q. Can you use simple English to explain why bond prices fall when interest rates up?
A. Bond is a contract between the borrower and the lender, the borrower promises to pay a fixed interest rate during the term of the contract.
Now assume a bond is issued today with face value of $100 and interest rate 5%, with 2 year term. This 5% interest rate is determined based on several factors, including the issuer's credit rating, as well as general market competition.
In one year, assume the external environment changed, Fed raised interest rates, so potential bond investors have better alternatives out there, if this bond still sells at 5%, it will not be competitive anymore.
If you are the bond holder and needs to sell the bond in one year, you have to lower the price of the bond to, say $95, so the new investors can get market competitive interest rate from this bond.
For you as the bond holder who didn't hold the bond till maturity, you lose some principal money, that's why bonds might not be safe investor vehicles in interest rising environment.
A. Bond is a contract between the borrower and the lender, the borrower promises to pay a fixed interest rate during the term of the contract.
Now assume a bond is issued today with face value of $100 and interest rate 5%, with 2 year term. This 5% interest rate is determined based on several factors, including the issuer's credit rating, as well as general market competition.
In one year, assume the external environment changed, Fed raised interest rates, so potential bond investors have better alternatives out there, if this bond still sells at 5%, it will not be competitive anymore.
If you are the bond holder and needs to sell the bond in one year, you have to lower the price of the bond to, say $95, so the new investors can get market competitive interest rate from this bond.
For you as the bond holder who didn't hold the bond till maturity, you lose some principal money, that's why bonds might not be safe investor vehicles in interest rising environment.
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