Final answer:
The market value of interest-bearing bonds is inversely related to changes in interest rates. As interest rates drop, bond values increase, and as rates rise, bond values decrease. This inverse relationship is due to the fixed coupon rates of bonds in comparison to fluctuating market interest rates.
Step-by-step explanation:
The market value (price) of most interest-bearing bonds trading on the secondary market is inversely related to changes in interest rates. When interest rates fall, existing bonds with higher coupon rates become more attractive, thus increasing in value. Conversely, if interest rates rise, new bonds are likely to be issued with higher coupons, making existing bonds with lower rates less attractive and decreasing their market value. The relationship between bond prices and interest rates is a fundamental principle in financial markets.
For example, if a bond was issued when interest rates were at 5% with a 5% coupon, it pays $50 annually. If market rates drop to 3.5%, the bond's fixed 5% coupon becomes more desirable, leading to an increase in its market value. On the other hand, if rates increase to 6.5%, the bond's lower coupon rate in comparison makes it less attractive, which results in a decrease in its market value. The value of a bond can be determined by calculating the present value of future expected payments, taking into account the current interest rates.