Final answer:
Bond prices and bond yields are inversely related. As bond prices increase, yields decrease, and vice versa. This relationship is pivotal for investors to understand when buying and selling bonds in the market.
Step-by-step explanation:
The relationship between bond prices and bond yields is that they are inversely related. This means when bond prices go up, yields go down, and vice versa. The main reason for this inverse relationship is that bonds typically pay a fixed interest rate over their lifetime. When market interest rates change, the fixed interest payment on existing bonds may become more or less attractive, depending on whether the market rates have gone up or down compared to the bond's rate. For example, if new bonds are issued at a higher interest rate, the value of existing bonds with lower rates falls because investors prefer the new bonds with higher yields. As a result, to sell an older bond in a higher interest rate environment, the price must drop to offer a competitive yield to the new rate.
To calculate bond yield, investors need to consider the bond's price, interest payments (or coupon payments), and the time remaining until the bond matures. The yield reflects the total returns that an investor can expect from a bond, based on its current price and coupon payments. Investors interested in the bond market should always remember the tradeoffs between return and risk, evaluating the quality of the bonds they are considering and considering diversifying their investments across different types of assets, such as stocks, mutual funds, and different categories of bonds.