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Difficulty: EasyDebt Securities and Bond Structure

When prevailing market interest rates increase, what typically happens to the market price of existing fixed-rate bonds in the secondary market?

  1. The market price of the existing bonds decreases.Answer
  2. B
    The market price of the existing bonds increases.
  3. C
    The market price remains unchanged because the coupon rate is fixed.
  4. D
    The market price increases to match the higher par value of new issues.

Answer

The market price of existing bonds decreases when prevailing market interest rates rise.
There is a fundamental inverse relationship between interest rates and bond prices. When market interest rates rise, newly issued bonds offer higher coupon payouts. To compete with these new issues, existing bonds with lower fixed coupon rates must drop in market price so that their yield to maturity rises to match prevailing market rates.

Step-by-Step Solution

1
Identify the core relationship between market interest rates and fixed-income market prices.
Bond prices and interest rates share an inverse relationship.
When new bonds are issued at higher interest rates, existing bonds paying lower fixed coupon rates become less attractive unless sold at a discount.
2
Determine the impact of rising rates on existing fixed-rate bond valuation.
The price of the existing bond must fall in the secondary market.
Lowering the market price increases the yield of the existing bond to match competitive current market yields.

Key Concept

Inverse Relationship Between Bond Prices and Interest Rates
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Topics

Debt Securities and Bond Structure

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