Chapter 3 of 15
Price Sensitivity and Risk
The inverse relationship between prices and rates
6 min read
Why do bond prices change?
The Inverse Relationship
Bond prices and interest rates move in opposite directions. This is the fundamental risk in fixed income investing.
When Interest Rates Rise
- New bonds offer higher coupons
- Existing bonds with lower coupons become less attractive
- Existing bond prices fall
When Interest Rates Fall
- New bonds offer lower coupons
- Existing bonds with higher coupons become more attractive
- Existing bond prices rise
Why Does This Happen?
The present value of future cash flows decreases when discount rates increase. Since a bond is a series of fixed cash flows, its value is inversely related to the rate used to discount those flows.
Credit Risk
Credit risk is the risk that the issuer cannot fulfill its payment obligations. It is measured by credit ratings (AAA = highest quality, D = default). Higher credit risk means higher yield demanded by investors. German Bunds are rated AAA—considered among the safest securities globally.
The Risk-Return Spectrum
German Bunds (AAA)
Investment Grade Corps (BBB+)
High Yield (BB and below)
GERMAN EXAMPLE
When the ECB raised rates from 0% to 4% (2022-2023), Bund prices fell significantly. A 10-year Bund could lose 15-20% of its market value in a rising rate environment. Conversely, when rates fall, existing Bunds with higher coupons appreciate.
KEY TAKEAWAY
Bond prices fall when rates rise. The longer the maturity, the bigger the move.