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Difficulty: EasyDebt Securities and Bond Structure

When prevailing market interest rates decline, what happens to the secondary market price of existing fixed-rate corporate bonds?

  1. The market price of existing bonds increases.Answer
  2. B
    The market price of existing bonds decreases.
  3. C
    The market price of existing bonds remains unchanged.
  4. D
    The market price fluctuates unpredictably regardless of interest rate changes.

Answer

The market price of existing bonds increases.
Existing bond prices rise when prevailing market interest rates decline because the fixed coupon payments of existing bonds are higher than those of newly issued bonds, making existing bonds more valuable to investors.

Step-by-Step Solution

1
Determine the relationship between prevailing market interest rates and fixed-income market prices.
Interest rates and bond prices have an inverse (opposite) relationship.
When market interest rates drop, newly issued bonds offer lower coupon yields. Consequently, existing bonds paying higher fixed coupon rates become more desirable to prospective buyers, driving up their secondary market price.

Key Concept

Inverse Relationship Between Interest Rates and Bond Prices
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Topics

Debt Securities and Bond Structure

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