Final answer:
Bond prices fluctuate based on the market interest rates and the creditworthiness of the issuer. Higher interest rates typically result in lower bond prices, while lower rates can increase bond prices. The risk of default by the issuer also impacts the price, with higher risks leading to lower prices.
Step-by-step explanation:
Bond prices fluctuate primarily based on two things: interest rates in the market and the creditworthiness of the issuer or, in other words, the risk of default.
When the prevailing interest rates increase, the prices of existing bonds typically decrease because new bonds are likely to be issued with higher coupon rates, making the older bonds with lower rates less attractive. Conversely, when interest rates fall, bond prices tend to rise.
The creditworthiness of a bond issuer affects its price because investors need to be compensated for the risk of the issuer defaulting on the payments. Higher perceived risk leads to higher required yields, which in turn can lower the bond's price. Bond yields and bond prices have an inverse relationship.
For example, a corporate bond with an annual coupon of 5% when interest rates are at the same level will generate $50 annually per $1,000 face value bond.
However, if the market interest rates fall to 3.5%, the value of this bond increases because it pays a higher interest rate compared to new bonds. Conversely, if market rates rise to 6.5%, the bond pays less than new bonds, making it less attractive and lowering its price.