Example: in january you buy a bond with a face value of 100 from a corporation issuing bonds to raise capital. The coupon rate is 5% which matches the market interest rate of 5%. in june, i decide to buy a bond. I have two choices: 1. Buy a bond from a corporation issuing bonds in june; or, 2. buy your existing bond. Assume in june that the market interest rate is now higher at 10%. The new issuer in june must offer a coupon rate that matches, to some degree, the current market interest rate. After all, thats what investors like me would expect to receive. When the issuer offers a bond with a 10% coupon rate when the market interest rate is 10%, the price of the bond would be par or 100. That means i could buy the new bond for 100. Or i could buy your bond. How much do You think i would be willing to pay for your bond that offers only a 5% coupon rate, when i could buy a new issue that offers a coupon rate of 10% for 100? Would i be willing to pay more than 100 for your bond or less? The answer, of course, is that there is no way im going to give you 100 for your bond when the same 100 buys a bond with a much higher coupon rate. youll have to lower your price in order to attract my attention. In fact, youll have to lower the price of your bond enough so that the yield on your bond matches the yield of the new bond issue if you have any hope of selling me your bond. From this example you can see that when interest rates went up, the price of existing bonds had to fall.
