Financial Assets & Why Bond Prices Move Opposite to Rates

You’ll be able to

Distinguish the main categories of financial asset by risk, return and liquidity
Explain the inverse relationship between bond prices and interest rates
Rank assets by liquidity and relate liquidity to expected return

What a financial asset is

A financial asset is a claim on someone else's future income. A bond is a loan — the issuer owes fixed payments and repayment of principal, so the holder is a creditor. A share of stock is partial ownership, so the holder receives residual profits and bears more risk. A bank deposit is a claim on a bank. All three trade off the same three properties: risk, expected return and liquidity. You cannot maximize all three, and the pattern is that higher expected return comes with higher risk or lower liquidity.

The inverse relationship, derived

A bond pays fixed dollar amounts. Suppose a bond pays $50 a year and sells for $1,000 — a 5% return. Now market interest rates rise to 10%. Nobody will pay $1,000 for $50 a year when new bonds pay $100, so the price of the old bond must fall until $50 represents a competitive return — around $500. The payment never changed; only the price did. This is why bond prices and interest rates move in opposite directions, and why the Fed buying bonds raises their price and lowers rates.

Bond yield

yield ≈ annual payment / price → price and yield move in OPPOSITE directions

The payment is fixed by contract. The only way the yield can change is for the price to move, which is the whole mechanism.

The liquidity ranking

Liquidity is how quickly an asset converts to a medium of exchange without losing value. Cash is perfectly liquid by definition. Checkable deposits are nearly so. Savings deposits and money market funds are close behind. Bonds and stocks require a sale at whatever price the market offers. Real estate is highly illiquid. The liquidity premium is the reason liquid assets pay less: you are paid to give up access to your money, which is exactly why the money market treats holding money as having an opportunity cost equal to the interest rate.

Worked example

A bond pays $80 per year and currently sells for $1,000. Market interest rates then fall to 4%. What happens to the bond's price, and why?

1.At $1,000 the bond yields 80/1,000 = 8%.
2.Newly issued bonds now pay only 4%, so this bond's $80 is unusually attractive.
3.Buyers bid the price up. The price rises until the yield matches the market.
4.Price ≈ 80/0.04 = $2,000.

Answer: The price rises to roughly $2,000. Falling market rates raise the value of existing fixed payments — which is why bondholders gain when rates fall and lose when rates rise.

Watch out

A bond's coupon payment never changes. When a question says "the bond's return rose", it means the yield rose because the price fell — a capital loss for anyone already holding it, not a windfall.

Checkpoint

Market interest rates rise. The price of previously issued bonds:

Checkpoint

Which asset is most liquid?

Checkpoint

The Federal Reserve buys government bonds on the open market. The immediate effect on bond prices and interest rates is that:

On the exam

The bond price–interest rate inverse appears in both multiple choice and free response, and it is the bridge between the Fed's open-market action and the interest rate the rest of the unit uses. Be able to state it in one sentence.

Answer the 3 checkpoints as you read.