What is the relationship between interest rates and bond prices?

The correct choice highlights a fundamental principle in bond investing: as interest rates rise, bond prices typically fall. This relationship can be understood through the fixed nature of bond payments. When interest rates increase, newly issued bonds offer higher yields to attract investors. As a result, existing bonds with lower interest rates become less attractive, causing their prices to drop in order to remain competitive in the market.

For example, if you hold a bond that pays a 5% coupon in a market where new bonds are paying 6%, the value of your bond will decrease because investors will prefer the new bonds that provide a better return. On the other hand, if interest rates fall, existing bonds with higher fixed rates become more attractive, driving their prices up. This inverse relationship between interest rates and bond prices is a key concept in finance and often guides investor decisions in the bond market.

Understanding this dynamic can help investors manage their bond portfolios effectively and anticipate the potential impact of changing interest rates on their investments.