Why bond prices move when interest rates change

What the bond promises

A conventional fixed-rate bond is a loan with specified payments. Its face value is the principal due at maturity; its coupon is the contractual interest payment. The issuer’s ability to meet those promises matters. A quoted market price is what someone is willing to pay for the remaining payments today.

For a basic glossary and the distinction between credit, inflation and liquidity risk, see the SEC’s investor education resource at https://www.investor.gov/introduction-investing/investing-basics/investment-products/bonds-or-fixed-income-products/bonds. The examples below deliberately leave out taxes, transaction costs, accrued interest and default.

Worked example: one payment, one year away

Imagine a bond that will pay £104 exactly one year from today: £100 principal plus £4 interest. If investors require a 4% return for this risk, the price is £104 ÷ 1.04 = £100. Buying at £100 and receiving £104 produces that 4% return.

If the required return rises to 6%, the same £104 payment is worth £104 ÷ 1.06 = £98.11 today. The issuer has not changed the payment. The buyer pays less to earn the higher required return. If the required return falls to 2%, the price rises to £104 ÷ 1.02 = £101.96.

This calculation compares alternative required returns at the same valuation date. It is not a forecast of where a particular bond will trade. In practice, the required yield reflects several influences, including interest-rate expectations and the issuer’s credit risk.

More years means more payments to discount

Consider a two-year bond paying £4 after year one and £104 after year two. At a 4% annual required return, its price is £4 ÷ 1.04 + £104 ÷ 1.04² = £100. At 6%, the price is approximately £96.33. Its percentage price decline is larger than in the one-year example.

This illustrates why the timing of the payments matters. Duration is a measure of sensitivity to changes in yields; it is related to, but different from, maturity. Longer-dated fixed-rate bonds generally have greater rate sensitivity than otherwise similar shorter bonds. The SEC explains this mechanism at https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins-86.

Coupon, current yield and total return

A £4 annual coupon on £100 face value is a 4% coupon rate. If that bond trades at £80, the coupon divided by price is 5%. That current yield ignores any eventual gain or loss between the purchase price and the principal repaid. Yield to maturity incorporates the contractual cash flows and price, subject to assumptions.

Total return over your actual holding period can include coupons and a change in market price. If you pay £100, collect a £4 coupon and sell for £95, the simple holding-period result is −1% before costs and tax. The coupon was positive; the combined result was negative. Do not use a coupon rate as a substitute for total return.

Common mistakes

Government-issued does not mean the market price cannot fall. Holding to maturity removes the need to sell at an intervening market price, but does not remove default risk or the loss of purchasing power from inflation. A payment received in a foreign currency also introduces exchange-rate uncertainty.

A bond fund is not the same as a single bond with your chosen maturity date. Its holdings may change, and the fund’s value fluctuates. Check its maturity profile, credit quality and costs. The SEC covers these distinctions at https://www.investor.gov/introduction-investing/investing-basics/glossary/bond-funds-and-income-funds.

Connect the mechanism to the wider economy

The same discounting logic appears in business valuation: higher required returns reduce the present value of a fixed set of future cash flows. Actual company values also depend on changing cash-flow expectations, so there is no automatic one-for-one relationship with a central-bank announcement.

Try changing only the discount rate in the valuation lab while holding the operating assumptions constant. Then change both. Write down which effect comes from the price of risk and which comes from the cash forecast. That separation makes market commentary easier to assess.