At first glance, the inverse relationship between interest rates and bond prices seems somewhat illogical, but upon closer examination, it makes good sense. An easy way to grasp why bond prices move in the opposite direction as interest rates is to consider zerocoupon bonds, which don't pay coupons but derive their value from the difference between the purchase price and the par value paid at maturity.
A Useful Example
For instance, if a zerocoupon bond is trading at $950 and has a par value of $1,000 (paid at maturity in one year), the bond's rate of return at the present time is approximately 5.26%, which is equal toÂ (1000 Â 950) Ã· 950.
For a person to pay $950 for this bond, he or she must be happy with receiving a 5.26% return. But his or her satisfaction with this return depends on what else is happening in the bond market.
The Best Return Possible
Bond investors, like all investors, typically try to get the best return possible. If current interest rates were to rise, giving newly issued bonds a yield of 10%, then the zerocoupon bond yielding 5.26% would not only be less attractive, it wouldn't be in demand at all. Who wants a 5.26% yield when they can get 10%?
To attract demand, the price of the preexisting zerocoupon bond would have to decrease enough to match the same return yielded by prevailing interest rates. In this instance, the bond's price would drop from $950 (which gives a 5.26% yield) to $909.09 (which gives a 10% yield).
Volatile Tendencies
This is why zerocoupon bonds tend to be more volatile,Â as they do not pay any periodic interest during the life of the bond. Upon maturity, a zero coupon bondholder receives the face value of the bond.
Thus, the only value in zerocoupon bonds is the closer they get to maturity, the more the bond is worth. Further, there is limited liquidity for zero coupon bonds since their price is not impacted by interest rate changes. This makes their value even more volatile.
Zero coupon bonds are issued at a discount to par value. Yields on zero coupon bonds are a function of the purchase price, the par value and the time remaining until maturity.Â However, zero coupon bonds alsoÂ lock inÂ the bondâ€™s yield, which may be attractive to some investors.
Unique Tax Implications
Still, zerocoupon bonds have unique tax implications that investors should understand before investing in them. Even though no periodic interest payment is made on a zerocoupon bond, the annual accumulated return is considered to be income, which is taxed as interest. The bond is assumed to gain value as it approaches maturity. The gain in value is not taxed at the capital gains rate but is treated as income.
Taxes must be paid on these bonds annually, even though the investor does not receive any money until the bond maturity date. This may be burdensome for some investors. However, there are some ways to limit these tax consequences.
How Bond Prices Move
Now that we have an idea of how a bond's price moves in relation to interestÂ rate changes, it's easy to see why a bond's price would increase if prevailing interest rates were to drop. If rates dropped to 3%, our zerocoupon bondÂ â€“ with its yield of 5.26%Â â€“ would suddenly look very attractive. More people would buy the bond, which would push the price up until the bond's yield matched the prevailing 3% rate.
In this instance, the price of the bond would increase to approximately $970.87. Given this increase in price, you can see why bondÂ holders (the investors selling their bonds) benefit from a decrease in prevailing interest rates.
TheseÂ examplesÂ also showÂ how aÂ bond's coupon rate is directly affected by national interest rates, and consequently,Â itsÂ market price. Newlyissued bonds tend to have coupon rates that match or exceed the current national interest rate.
When people refer to "the national interest rate" or "the fed," they'reÂ most often referringÂ to theÂ federal funds rateÂ set by theÂ Federal Open Market Committee (FOMC).Â This is the rate of interest charged on the interbank transfer of funds held by the Federal Reserve and is widely used as aÂ benchmarkÂ for interest rates on all kinds of investments andÂ debt securities.
The Bond Market's March 2017 Fall
For this reason, when the Federal Reserve increased interest rates in March 2017 by a quarter percentage point, the bond market fell. The yield on 30year Treasury bonds dropped to 3.108% from 3.2%, the yield on 10year Treasury notes fell to 2.509% from 2.575%, and the twoyear notes' yield fell from 1.401% to 1.312%.
For a more detailed explanation of bond pricing and yield calculations, check out Advanced Bond Concepts.

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