# Why Bond Prices Fall when Yields Rise

A bond is a promise to pay a debt at some point in the future.  Those debts can be issued by a government or by a company in order to raise money, and investors can either buy the bonds with the plan to hold them for the purpose of collecting on the debt, or they can buy and sell the bonds for the purpose of making a profit on those trades.  Bond prices and bond yields are in an inverse relationship: when one rises the other falls, and vice versa.  This is because bonds trade at a discount rate to reflect the time and risk between owning a bond now and collecting on the bond’s promise in the future.

To simplify, imagine that a company, city, or state wants to raise money to build something.  The project will cost \$100,000 and the issuer believes they can pay that back in one year.  The issuer sells the bond for \$100,000, but nobody is willing to give up their money for a year without getting something in return.  So the issuer has to agree to pay a certain amount more than the purchase price.  Depending on a number of market conditions, the issuer will have to pay back more than the amount borrowed.

In reality, the bond likely has a fixed redemption value and the purchase price is set somewhere below.  But the effect is the same: bonds are sold for an amount less than they will be worth at some point in the future.  The amount of extra money that the bond will be worth is called the yield.  If a bond sells for \$100 and it can be redeemed in one year for \$110, then the bond has a 10% yield.  If the price of the bond falls to \$90, the bond yield will rise to 22% (110-90) ÷ 90).

What might make a bond price fluctuate up or down, and therefore make the yield go down or up?  There are a number of possibilities.  One is the perception from investors of whether they believe the issuer will pay back the debt.  If an investor buys a bond for a company that is on the verge of collapsing, there is a greater chance that the issuer will repudiate the bond and refuse to pay.  If that is the case, the bond will eventually be worthless.  So the investor will be less willing to pay for it, driving down the price.  As the price falls, the gap between the price and the promised payout grows, leading the yield to rise.

A bond price might also rise or fall depending on the relative value of other investments.  If investors are worried that the stock market or real estate are overpriced or risky, the investors might flock to bonds.  Many people trying to buy a limited quantity will drive the price up.  When the price goes up, the gap between the price and the promised payout narrows, and the yield goes down.  This reflects the market’s reaction to the fact that more people want that bond and therefore they are willing to tolerate a smaller yield in exchange for holding that preferred investment.

In the end, the reason that bond prices and yields move in opposite directions is because the price represents a discount on the eventual value of the promise to pay money.  Depending on investors’ beliefs about the market or the financial soundness of the issuer of the bond, the prices will reflect more of a discount or less of a discount, leading to higher yields and lower yields respectively.