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Difficulty: EasyDebt Securities and Bond Structure

If prevailing market interest rates rise, which of the following best describes the immediate effect on the secondary market price of an existing fixed-rate bond?

  1. The market price of the bond decreases.Answer
  2. B
    The market price of the bond increases.
  3. C
    The market price of the bond remains unchanged because its coupon rate is fixed.
  4. D
    The market price of the bond increases due to inverted yield curve dynamics.

Answer

The market price of the bond decreases.
There is a fundamental inverse relationship between market interest rates and fixed-income security prices. When interest rates rise, existing bonds with lower fixed coupon rates become less competitive compared to new bonds paying higher rates. Consequently, sellers must discount the price of existing bonds to attract buyers.

Step-by-Step Solution

1
Identify the relationship between interest rates and bond prices.
Bond prices and interest rates move in opposite directions (an inverse relationship).
When market interest rates increase, newly issued bonds offer higher yield payments than existing bonds with lower fixed coupon rates.
2
Determine the impact of rising rates on existing fixed-rate bonds.
To compete with higher-yielding new issues, the secondary market price of the existing bond must fall until its yield matches market rates.
Discounting the price increases the effective yield for buyers in the secondary market.

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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