Discuss the relationship between bond prices and interest rates. What impact do changing interest rates have on the price of long-term bonds versus short-term bonds?
The correlation between bonds and interest rates is inverse. When trying to borrow cash, expenses increase, bonds typically fall conversely even before interest rates increase. At the first glimpse, there is a rather irrational negative correlation between interest or even bond rates. It usually starts making general understanding, however, after intense scrutiny.
Thus many bonds charge a fixed percentage that is more appealing when interest rates decline, demand rises, and bond prices increase.
Alternatively, when interest rates increase, the reduced fixed interest rate that the bond earns is no longer preferred by investors, which leads to a reduction in its market value.
Zero-coupon bonds illustrate clearly how this framework works in reality.
While interest rates increase, bond prices decrease (and conversely), and long-term bonds are more vulnerable to changes in the rate.
Long-term bonds are lengthier than short-term bonds, which are fairly close to expiration and are subject to less accrued interest.
Long-term bonds are also much more subject to fluctuating interest rates over the remainder of their life.
Through sustainability or using hedge funds of interest rates, fund managers can hedge market volatility of interest rates.