When you buy a bond, either directly or through a mutual fund, you're lending money to the bond's issuer, who promises to pay you back the principal (or par value) when the loan is due (on the bond's maturity date). In the meantime, the issuer also promises to pay you periodic interest payments to compensate you for the use of your money. The rate at which the issuer pays you – the bond's stated interest rate or coupon rate – is generally fixed at issuance.
An Inverse Relationship
When new bonds are issued, they typically carry coupon rates at or close to the prevailing market interest rate. Interest rates and bond prices have "inverse relationship" – meaning, when one goes up, the other goes down. The question is: how does the prevailing market interest rate affect the value of a bond you already own or a bond you want to buy from or sell to someone else? The answer lies in the concept of "opportunity cost." Investors constantly compare the returns on their current investments to what they could get elsewhere in the market. As market interest rates change, a bond's coupon rate – which, remember, is fixed – becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself. Let's look at an example. Suppose the ABC Company offers a new issue of bonds carrying a 7% interest rate. This means it would pay you Rs. 70 a year in interest. After evaluating your investment alternatives, you decide this is a good deal, so you purchase a bond at its par value, Rs.1, 000.
What if Rates Go Up?
Now let's suppose that later that year, interest rates in general go up. If new bonds are sold at Rs. 1,000 and interest is 8% (Rs.80 a year in interest), buyers will be reluctant to pay you face value (Rs. 1,000) for your 7% ABC bond. In order to sell, you'd have to offer your bond at a lower price – a discount – that would enable it to generate approximately 8% to the new owner. In this case, that would mean a price of about Rs. 875.
What if Rates Fall?
Similarly, if rates dropped to below your original coupon rate of 7%, your bond would be worth more than Rs. 1,000. It would be priced at a premium, since it would be carrying a higher interest rate than what was currently available on the market. Of course, many other factors go into determining the attractiveness of a particular bond: the length of time until the bond matures, whether or not its interest is taxable, the creditworthiness of its issuer, the likelihood that the issuer will pay off debt early, and more. But the important thing to remember is that change, be it major or minor occurs in market interest rates virtually every business day. The movement of bond prices and bond yields is simply a reaction to that change.
Inflation Rates and Bond Prices also have inverse relationship, because in order to contain inflation in the country, the RBI through open market operations to control money flow interest are hiked, when bond prices rises and vice versa.