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Question

Difficulty: EasyGovernment, Municipal, and Corporate Bonds

An investor observes that prevailing market interest rates have risen over the past several months. How will this increase in interest rates affect the market price of an existing fixed-rate corporate bond?

  1. The market price of the bond will decrease.Answer
  2. B
    The market price of the bond will increase.
  3. C
    The market price of the bond will remain unchanged because the coupon rate is fixed.
  4. D
    The market price of the bond will fluctuate solely based on changes in the issuing company's credit rating.

Answer

The market price of the bond will decrease because bond prices move inversely to interest rates.
The correct option states that the market price of the bond will decrease. Bond prices and interest rates move in opposite directions. When market interest rates rise, existing bonds paying lower fixed coupon rates become less attractive unless their prices fall to offer a competitive yield in the secondary market.

Step-by-Step Solution

1
Identify the relationship between prevailing market interest rates and fixed-income market prices.
Bond prices and market interest rates share an inverse relationship.
When market rates rise, newly issued bonds offer higher yield payments than existing bonds with lower fixed coupon rates.
2
Evaluate the effect of rising rates on an existing fixed-rate bond.
To compete with newly issued higher-yielding bonds, the price of the existing bond must drop.
Lowering the market price increases the yield for prospective buyers in the secondary market.

Key Concept

Inverse Relationship Between Bond Prices and Interest Rates
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Topics

Government, Municipal, and Corporate Bonds

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