Bonds are generally issued with a fixed interest rate known as the coupon rate.
While this coupon rate is fixed, interest rates in general are not. They keep moving up and down. It is this movement in interest rates that influences the market price of an existing bond.
When the interest rates rise, the market price of an existing bond will tend to fall. The opposite will happen when the interest rates falls. The market price of an existing bond in such a scenario will rise. The quantum of this rise or fall will depend upon the coupon rate of the bond.
Now that we have observed how the price of a bond moves with changes in the interest rates, we will attempt to answer the question - what brings about this change?
The answer lies in the fact that bonds with different coupon rates, issued at different points in time, will tend to yield the same return of their investors.
This is better explained with the help of an example.
Let us assume that the Government of India issues bonds of a face value of 1,000 with a fixed coupon rate of 8% p.a on January 1, 20X6. During the course of the year, on account of an easing inflationary situation, the interest rates in general come down. On the beginning of the next year, the Government makes a fresh issue of bonds with face value of 1,000; this time carrying a coupon rate of 6% p.a.
In such a scenario, the market price of the earlier issue of bonds will quickly rise to the point that the yield on both the issues for a new investor would be identical.
So the market price of the earlier issue of bonds would rise to 1,334.
For a new investor, the effective yield on the earlier issue can be calculated as follows.
Market Price of the Bond = 1,334
Face Value of the Bond = 1,000
Coupon Rate = 8% p.a
Annual Interest Income = 80
Effective Yield = 80/1,334 x 10
= 6% p.a
The market price and face value of the new issue being similar, the yield on the new issue will be the same as the coupon rate i.e 6% p.a.
The market price of different issues will therefore adjust itself to yield the same returns for its investors.
This explains why the market price of a bond fluctuates with changes in interest rates.
To sum up, the value of a bond and interest rates move in opposite direction.