When market yields go up, the prices of bonds traded in the market:
A. Appreciate B. Depreciate C. Stay the same D. Cannot be determined
The correct answer and explanation is:
The correct answer is B. Depreciate.
When market yields rise, bond prices typically decrease. This inverse relationship between bond prices and yields is fundamental in bond markets. Here’s why:
- Bond Price and Yield Relationship: A bond’s yield is essentially its return on investment. The yield is inversely related to the bond’s price. When market yields go up, the fixed interest payments (or coupon payments) on existing bonds become less attractive compared to new bonds issued at the higher yield. As a result, investors are less willing to pay as much for the older bonds, causing their prices to fall.
- Fixed Coupon Payments: Bonds generally pay fixed coupon payments based on the bond’s face value. If new bonds are issued with higher interest rates, the older bonds with lower coupon rates lose their attractiveness. To compensate for this, the prices of the older bonds must fall so that their yield matches the prevailing market rate.
- Example: Consider a bond paying a 5% coupon in an environment where the prevailing market yield rises to 6%. Investors will demand a discount on the older bond to align its effective yield with the current market conditions. If the price of the bond drops enough, the effective yield will increase, making it more comparable to the higher yields on new bonds.
- Market Adjustment: This price adjustment mechanism ensures that the yield on existing bonds moves in line with market rates. If yields increase, bond prices fall, and conversely, if yields decrease, bond prices rise.
In summary, when market yields rise, the prices of bonds fall (depreciate) because the fixed coupon payments are less attractive compared to newly issued bonds at the higher yield.