If overall interest rates in the economy rise, a corporate bond with a fixed interest rate will generally
Multiple Choice
A Increase in value.
B Decrease in value.
The correct answer and explanation is:
The correct answer is B: Decrease in value.
When interest rates in the economy rise, the value of existing corporate bonds with fixed interest rates typically decreases. This occurs because newly issued bonds will offer higher interest rates to reflect the increased market rates. As a result, investors seeking better returns will demand higher yields, making the fixed-rate bonds less attractive.
Here’s how it works: Corporate bonds pay a fixed coupon, which is a set interest rate on the bond’s face value. If market interest rates rise, new bonds are issued with higher coupon rates to match the increased rates. For example, if you hold a bond with a 4% coupon rate, but new bonds are being issued at 6%, your bond with the 4% coupon is less attractive.
To compensate for the lower yield, the price of your bond must fall. When the bond’s price drops, the yield increases to a level that aligns more closely with the current market interest rates. The drop in price ensures that investors are willing to buy the older bond with a lower coupon, as the yield they will receive is comparable to that of newer bonds issued at higher rates.
In the bond market, the relationship between bond prices and interest rates is inverse. When rates go up, bond prices go down. This effect is particularly pronounced for long-term bonds, which are more sensitive to interest rate changes because they lock in fixed interest payments over a long period. The longer the maturity, the more the bond’s price will fluctuate with changes in interest rates.
In conclusion, when interest rates increase, the value of a corporate bond with a fixed interest rate generally decreases as investors move to higher-yielding alternatives.