Interest rates and bond prices move in opposite directions—when interest rates rise, existing bond prices fall, and when rates fall, bond prices rise. This inverse relationship exists because bonds pay a fixed coupon (interest payment), so if new bonds are issued with higher rates, older bonds paying lower coupons become less attractive and must trade at a discount to compete. Conversely, if rates drop, older bonds paying higher coupons become more valuable.
The duration of a bond (roughly, how long until you receive your money back) determines how sensitive it is to rate changes. Longer-duration bonds experience larger price swings when rates change, while shorter-duration bonds are more stable. A 10-year bond, for example, will fluctuate more than a 2-year bond when rates move by 1%.
Interest rates also affect bond yields, which represent the return you'd earn if you buy a bond today and hold it to maturity. Rising rates increase yields on newly issued bonds, making them more attractive for savers seeking income. However, if you need to sell a bond before maturity and rates have risen since you bought it, you'll face a capital loss because you must sell at a discount.
This relationship is fundamental to bond investing: higher rates offer better future income but create immediate price risk for current bondholders. Central banks' interest rate decisions therefore significantly influence bond markets and are closely watched by investors seeking to anticipate price movements.