How do bond prices respond to interest rate changes?

Bond prices move inversely to prevailing interest rates because a bond’s fixed future payments become more or less valuable when discount rates change. John C. Hull at the University of Toronto explains that the price of a bond is the present value of its promised cash flows, and when market yields rise the discount factors increase so the present value falls. The opposite happens when yields decline, so existing bonds with higher coupons become more valuable relative to new issuance.

Inverse relationship, duration and convexity
Interest rate sensitivity is commonly summarized by duration and convexity. Duration measures the weighted average time to receive a bond’s cash flows and approximates the percent price change for a small change in yield. Longer duration bonds, such as long-term government or zero coupon securities, therefore experience larger price swings for a given interest rate move. Convexity captures the fact that the price-yield relationship is curved rather than linear, so for large yield changes the duration approximation understates price gains and overstates price losses. John C. Hull at the University of Toronto discusses both duration and convexity as central tools for assessing and hedging interest rate risk.

Monetary policy, market expectations and real-world consequences
Central bank policy shifts and changing expectations about inflation and growth drive interest rate movements. The Board of Governors of the Federal Reserve System describes how policy rate decisions primarily influence short-term rates while expectations and term premia affect the whole yield curve. When policy tightens, short rates rise and longer-term yields may follow if inflation expectations adjust, transmitting higher borrowing costs through mortgage, corporate and sovereign funding. Conversely, easing typically lowers yields and raises bond prices.

The consequences are widely felt across households, institutions and territories. Rising yields can create capital losses for fixed-income investors, strain pension funds and insurers with long-duration liabilities, and increase government borrowing costs, with particular impact on countries and municipalities that depend on frequent refinancing. In emerging markets, higher global rates often lead to capital outflows and currency pressure for borrowers with dollar-denominated debt, a dynamic noted in analyses by the Bank for International Settlements. Lower yields can benefit borrowers but compress returns for savers and can push investors toward riskier assets in search of income, with implications for financial stability and wealth distribution.

Practical responses by investors and issuers focus on risk management and adaptation. Portfolio managers use duration matching, laddered maturities and derivatives to hedge exposure, while issuers may lock in fixed rates or restructure maturities to reduce refinancing risk. Understanding the interplay between interest rates and bond prices clarifies why shifts in monetary policy or market sentiment rapidly affect financial conditions, public budgets and household finances across different cultural and territorial contexts.