Quick Answer
Bond prices and yields move in opposite directions: rates up, prices down. A bond trades at a discount, premium, or par depending on how its coupon compares to prevailing market rates, and every bond's price pulls toward par at maturity. Longer maturity and lower coupon both increase price volatility.
Now that you understand how yields are calculated, you can see what drives them: the bond's market price. This section covers the most fundamental principle in fixed income (the inverse relationship between price and yield) and the factors that determine how sensitive a bond's price is to rate changes.
The Inverse Relationship Between Price and Yield
This is the single most important concept in bond investing:
- Bond prices and interest rates (yields) move in opposite directions
- When market interest rates rise, existing bond prices fall (their fixed coupon becomes less attractive compared to new bonds)
- When market interest rates fall, existing bond prices rise (their fixed coupon becomes more attractive compared to new bonds)
Think of it this way: A bond's coupon is locked in at issuance. If new bonds offer 7% and yours pays 5%, no buyer will pay full price for yours. Your bond's price has to drop until its effective yield matches the market. When rates fall, the opposite happens; your 5% coupon looks generous, so buyers bid the price up.
Discount, Premium, and Par Bonds
The relationship between a bond's coupon rate and prevailing market rates determines whether it trades at a discount, premium, or par.
| Bond Type | Price vs. Par | Coupon Rate vs. Market Rate | Capital Effect at Maturity |
|---|---|---|---|
| Discount | Below $1,000 | Coupon lower than market | Capital gain (price rises to par) |
| Premium | Above $1,000 | Coupon higher than market | Capital loss (price falls to par) |
| Par | Equals $1,000 | Coupon equals market | No gain or loss |
- Discount bonds: The discount represents additional return (capital gain) earned at maturity. As the bond approaches maturity, the price pulls toward par
- Premium bonds: The premium represents a capital loss absorbed at maturity (only par is returned). As maturity nears, the price pulls toward par
- Par bonds: All yields (nominal yield, current yield, and yield to maturity) are equal when a bond trades at par
Exam Tip: Gotchas
- A bond's price always converges toward par as maturity approaches, whether it is trading at a discount or premium. At maturity, every bond is worth exactly $1,000 (par).
Factors Affecting Bond Price Sensitivity
Two characteristics determine how much a bond's price moves when interest rates change:
Coupon Rate
- Lower coupon bonds are more volatile (more sensitive to rate changes) than higher coupon bonds
- A zero-coupon bond has the greatest sensitivity because the investor receives no cash flow until maturity; all return depends on the final payment
Maturity
- Longer maturity bonds are more volatile than shorter maturity bonds
- A longer time horizon means more future cash flows are affected by the rate change
Combined Effect
| Characteristic | Most Volatile | Least Volatile |
|---|---|---|
| Coupon rate | Low (or zero) | High |
| Maturity | Long | Short |
| Combined | Long-term, zero-coupon | Short-term, high-coupon |
Exam Tip: Gotchas
- The exam frequently asks "which bond is most sensitive to interest rate changes?" Always pick the one with the longest maturity AND lowest coupon. A 30-year zero-coupon bond is the most volatile fixed-income instrument.
Basis Points
- A basis point (bp) is 1/100th of 1% (0.01%)
- 100 basis points = 1%
- Used to express small changes in yields and interest rates
Example: If a bond's yield moves from 4.50% to 4.75%, it has increased by 25 basis points
Value of a basis point: The dollar price change in a bond for a 1-basis-point change in yield. For a bond priced at par, 1 basis point is approximately $0.10 per $1,000 bond (varies with maturity and coupon).
Dollar Price vs. Basis (Yield) Price
Bonds can be quoted two different ways depending on the type of security:
| Quoting Method | What It Means | Used For |
|---|---|---|
| Dollar price | Percentage of par (e.g., 98.50 = $985 per $1,000; Treasuries express the fraction in 32nds) | Corporate bonds, government bonds |
| Basis price (yield price) | Quoted by yield to maturity (YTM) (e.g., 5.25 means YTM is 5.25%) | Municipal bonds |
Quoting conventions by security type:
- Corporate bonds: Dollar price (percentage of par in decimals or eighths)
- Municipal bonds: Often quoted on a yield basis (YTM or yield to call (YTC))
- Government bonds: Dollar price (percentage of par in 32nds)
- Example: A Treasury quoted at 99-16 means 99 and 16/32 = 99.50% of par = $995.00
Exam Tip: Gotchas
- Government bonds are quoted in 32nds, not decimals. A quote of 99-16 is $995.00, not $99.16.
- Municipal bonds are typically quoted on a yield basis (YTM or YTC), not a dollar price. If you see a muni quoted at "5.25," that is the yield, not the price.
What Should You Check on Exam Day?
- Rates and prices always move opposite each other; memorize this before anything else in the unit.
- The most volatile bond is long-term with the lowest (or zero) coupon; the least volatile is short-term with a high coupon.
- 1 basis point = 0.01%; 100 basis points = 1%.
- Government bonds quote in 32nds (99-16 = $995.00); corporates quote in decimals/eighths; municipals typically quote on a yield basis.