How might bond prices react when there is an increase in interest rates?

When interest rates rise, bond prices typically decrease due to the inverse relationship between bond prices and interest rates. This can be understood through the concept of opportunity cost. When new bonds are issued at higher interest rates, existing bonds with lower coupon rates become less attractive to investors. As a result, the market adjusts by lowering the prices of existing bonds to align their yields with the new market rates.

For example, consider a bond that pays a fixed interest rate of 4%. If newly issued bonds start yielding 5% due to an increase in interest rates, the older bond is less appealing. The only way for the older bond to compete is for its price to decrease, thereby increasing its yield to match the new prevailing rates. This adjustment helps maintain equilibrium in the bond market, illustrating how bond prices respond to changes in interest rates.

Thus, the response of bond prices to an increase in interest rates is a fundamental principle in the study of debt and money markets.