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Difficulty: EasyDebt Securities and Bond Structure

An investor holds an existing corporate bond with a fixed coupon rate of 5%. If prevailing market interest rates subsequently rise to 6%, which of the following best describes the immediate effect on the market price of the existing 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 adjust upward to match the new 6% yield directly.

Answer

The market price of the bond will decrease.
Market interest rates and existing bond prices have an inverse relationship. When prevailing interest rates rise, newly issued bonds offer higher returns. Consequently, the market value of existing bonds paying lower fixed coupon rates must fall so their effective yield becomes competitive with current market rates.

Step-by-Step Solution

1
Recall the fundamental relationship between market interest rates and fixed-income security prices.
Bond prices and interest rates share an inverse relationship.
When market interest rates rise, newly issued bonds pay higher interest payments, causing existing fixed-rate bonds with lower yields to sell at a discount.
2
Apply this relationship to the scenario provided.
As market rates rise from 5% to 6%, the market value of the 5% bond declines.
To yield a competitive return equivalent to 6%, the market price of the existing 5% bond must drop below par.

Key Concept

Inverse relationship between interest rates and bond prices
Estimated Time:45s
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Topics

Debt Securities and Bond Structure

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