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Difficulty: EasyDebt Securities and Bond Structure

An investor holds a corporate bond paying a fixed coupon rate of 5%5\%. If prevailing interest rates in the market rise to 6%6\%, what will happen to the bond's market price?

  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 automatically increase to match the 6%6\% yield.
  4. D
    The market price of the bond will remain completely unaffected because the coupon rate is fixed.

Answer

The market price of the bond will decrease.
There is a fundamental inverse relationship between market interest rates and fixed-income bond prices. When market interest rates rise, newly issued bonds yield higher interest, making existing bonds paying lower fixed rates less desirable. Consequently, the secondary market price of existing bonds decreases to adjust their yield upward to market levels.

Step-by-Step Solution

1
Identify the relationship between prevailing market interest rates and fixed-income bond prices.
Bond prices share an inverse (opposite) relationship with market interest rates.
When market rates rise above a bond's fixed coupon rate, newly issued bonds offer higher returns, driving down demand and price for existing lower-yielding bonds.
2
Apply the rate increase scenario to the bond.
Since market rates increased from 5%5\% to 6%6\%, the existing 5%5\% bond must sell at a discount (lower price) to offer a competitive yield.
Lowering the purchase price increases the effective yield for secondary market buyers.

Key Concept

Inverse Relationship Between Bond Prices and Interest Rates
Estimated Time:45s
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Topics

Debt Securities and Bond Structure

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