What Is the Effect on Interest Rates When Bonds Rise?

Bonds that are traded in securities markets all pay a fixed sum of money each year called the "coupon rate." Since this is a fixed amount, the effective interest rate (called the "yield") depends on the price of the bond. Thus, there is an effect on interest rates when bond prices rise. The key to understanding the price/yield relationship is to know what market factors will probably cause bond prices to go up.

Lower Interest

When bond prices rise, you pay more for the bond but still receive the same amount of money (coupon rate) per year. This results in a lower effective interest rate.

Prevailing Rates

If prevailing interest rates (market rates at any given time) fall, bond yields become more attractive, increasing demand, which drives up the bond's price, making the interest rate fall.

Credit Risk

Investors will pay more if a bond's rating of creditworthiness is upgraded, since that means the bond carries less risk.

Maturity

If a bond is selling at a discount from its par value, the bond price will rise as the bond approaches maturity, lowering the yield.

Inflation

Inflation is a cost factored into prevailing interest rates. If inflation falls, bond prices may rise even before prevailing interest rates drop in response to the lower inflation rate.