When interest rates go up, prices for bonds and bond funds fall and vice versa. The following examples show the relationship between bond prices and rates.
Municipalities and corporations sell bonds for financing. The issuer who sells the bond pays the buyer interest while the bond is outstanding, and then pays the principal back when the bond is due, that is, when it matures.
The price of the bond is fixed, as far as the issuer is concerned. If the company sells a $1,000 bond with a 5% interest rate to be paid back in 30 years, the buyer will receive $50 a year in interest, and then receive $1,000 back at the end of 30 years, if he has not sold the bond in the meantime
Changes in the Price of Municipal or Corporate Bond
If the bondholder keeps the bond to maturity, the changes in price of the bond are not important. If the bondholder does wish to sell the bond on the open market before maturity, he will have to take into account the price movements.
Consider the example above: if the bondholder elects to sell the bond after five years, he will have to take the price that the market dictates. If market interest rates have increased in that time, he will find that the price he can sell the bond at has decreased. It is an inverse relationship.
Why? If market interest rates are now 6%, no one is going to pay full price for a bond that only yields 5%. He will have to sell his bond at an appropriate discount, so that the new buyer will achieve the same effective interest rate as he could when buying a new bond.
The opposite situation is also true. If interest rates go down, the bondholder will find that his bond is now worth more. New buyers will be willing to pay more, that is, pay a premium, for a bond with a 5% interest rate, when new bonds are only carrying a 4% rate.
The amount of discount or premium depends on the difference in rates and how long until maturity. Interest rates are different based on whether the bonds are tax free or taxable.
Why Changes in Interest Rates Effect Bond Fund Prices
Bonds are also held by mutual funds. Funds can be comprised of only fixed investments like bonds, or can hold both stock and bond instruments. Since mutual funds can hold many bonds, some of the bonds are likely maturing regularly and are replaced with new bonds. Bonds in bond funds are also bought and sold, so the mutual fund undergoes the same changes in price as mentioned above.
Since anyone can buy or sell fund shares at the end of each day, bond funds, like other mutual funds, must be priced out every day. The price of the bond fund depends on how much interest has been earned but not paid out, and the premium or discount that the bonds would require if the bonds were sold that day, whether were actually sold or not.
Bond and bond fund prices move up and down based on the market. Buying a bond can be a stable investment, but can be subject to the same market forces as stocks if the bondholder wants to sell the bond before maturity.