Why Bond Prices Fall When Yields Rise—and Vice Versa

A bond that was issued with a 4% coupon does not suddenly start paying 5% because market yields rise. Instead, its market price changes. That price adjustment gives a new buyer a higher or lower return from the bond’s existing payments.

This distinction resolves the apparent contradiction behind the bond “seesaw”: the cash payments can stay fixed while the return available at today’s price changes.

The fixed payment is the starting point

When a bond is issued, its coupon rate is established and remains unchanged throughout the bond’s life. A bond with a $1,000 face value and a 4% coupon therefore pays $40 in interest per year.

But $1,000 is the bond’s face—or par—value, not necessarily the price someone will pay for it later. A bond or note can trade at, above or below par during its life in the market.

That difference between a fixed payment and a changing purchase price creates the inverse relationship:

• Pay less for the same future cash flows, and the yield is higher.
• Pay more for those cash flows, and the yield is lower.

This is why price and yield are inversely related even though the bond’s stated coupon rate has not changed.

A $1,000 bond at three different prices

Consider three otherwise identical bonds, each with a $1,000 face value, a 4% coupon rate and 10 years to maturity. Each pays the same $40 annually, but each is purchased at a different price.

The prices and yields to maturity come from a comparison of bonds with the same face value, coupon and maturity, while the current yields above apply the coupon divided by market price calculation to those prices.

The direction is easy to see. The buyer paying $900 receives the same $40 annual payment as the buyer paying $1,100, but commits $200 less. The lower-priced bond therefore has the higher current yield.

Yield to maturity, or YTM, produces different figures because it is broader than current yield. It measures the annual return if the bond is bought at its market price and held to maturity, taking account of what the buyer paid as part of that return. Its calculation incorporates the coupon payments and repayment of principal.

For the $900 bond, receiving $1,000 at maturity means getting back $100 more than the purchase price, assuming the promised payments are made. For the $1,100 bond, the $1,000 maturity payment is $100 less than the purchase price. That is why the discount bond’s YTM is above its current yield, while the premium bond’s YTM is below it.

Why changing market rates move an existing bond’s price

Suppose an existing bond pays a 3% coupon. If market rates later rise to 4%, that bond still pays 3% and must compete with newly issued bonds paying 4%. Its price is therefore more likely to fall. As the purchase price falls, its yield to maturity rises for a new buyer.

If market rates instead fall to 2%, the existing 3% bond continues paying its higher stated rate. Its market price is more likely to rise, and the higher price reduces the yield available to its next buyer. This is the mechanism behind the principle that market rates and fixed-rate bond prices generally move in opposite directions.

The sequence can be read from either end:

Higher market rates → lower existing bond prices → higher yields at those prices

Lower market rates → higher existing bond prices → lower yields at those prices

The yield is not rising because the issuer increased the bond’s coupon. It is rising because a buyer can acquire the unchanged future payments for less money.

Coupon rate, current yield and YTM answer different questions

These three percentages are easy to confuse because all can be described as a bond’s “yield” or rate:

• Coupon rate: What annual interest rate was established when the bond was issued?
• Current yield: How large is the annual coupon payment relative to the bond’s current market price?
• Yield to maturity: What annual rate reflects the purchase price and all scheduled coupon and principal cash flows through maturity?

YTM is widely used to compare bonds, but it is not a guaranteed realized return. Its computation assumes coupon and principal payments are made on time and generally assumes reinvestment of coupon payments; it also does not include taxes or brokerage costs. For those reasons, YTM is an estimate rather than a final calculation of total return.

A changing price does not rewrite the bond

The inverse relationship primarily describes the market value of a fixed-rate bond and the yield offered to someone buying at that value. It does not mean every price movement changes the contractual coupon payment.

If a bond is held to maturity, it continues paying its stated interest and returns its face value at maturity, subject to default risk throughout the holding period. If the bond is sold before maturity, however, the prevailing market price determines what the seller receives.

Nor does the seesaw show how large a price move will be. A bond’s maturity and coupon rate generally affect its sensitivity to changes in market rates. When other characteristics are the same, a lower-coupon bond will generally experience a larger price decline than a higher-coupon bond if rates rise, making interest-rate sensitivity dependent on bond features as well as the direction of rates.

Sources

1. Understanding Bond Yield and Return — finra.org
2. Understanding Pricing and Interest Rates — TreasuryDirect — treasurydirect.services.treasury.gov
3. What Are Corporate Bonds? | Investor.gov — investor.gov
4. When Interest Rates Go Up, Prices of Fixed-Rate Bonds Fall — investor.gov
5. Interest rate risk — — sec.gov