Imagine you bought a bond for $1,000 with a fixed interest rate of 3%. The interest rate prevailing in the market at that time was also 3%. Now, let's say interest rates rise to 4%.
If you decide to sell your bond with a 3% interest rate in a market where new bonds are offering 4%, potential buyers won't be willing to pay the original $1,000 for your bond, as they could get a new one with a better return. To make your bond more attractive, you might have to reduce its price.
In this scenario, your bond's price might drop to, let's say, $950. Now, the buyer still receives the same $30 annual interest (3% of $1,000), but since they paid only $950 for the bond, their effective yield is higher than 3%.
So, as interest rates rise, the prices of existing bonds tend to decrease to align with the higher rates available in the market. This inverse relationship between interest rates and bond prices is a fundamental dynamic in the bond market.